Cellcom Israel Ltd Q2 2008 Earnings Call Transcript

Cellcom Israel Ltd (CEL)

Q2 2008 Earnings Call

August 13, 2008 8:30 am ET

Executives

Ehud Helft - Investor Relations

Amos Shapira - Chief Executive Officer

Tal Raz - Chief Financial Officer

Analysts

Daniel Meron - RBC Capital Markets

[Stan Minneman] - [Extansis]

Al Kabili - Goldman Sachs

Alex Kuznetsov - ING

Stephen Pettyfer - Merrill Lynch

[Liore Usquaq] - [Merrill Investments]

Johnson Ho - William Blair

Presentation

Operator

Ladies and gentlemen, thank you for standing by. Welcome to Cellcom Israel Ltd Second Quarter 2008 Results Conference Call. All participants are at present in a listen-only mode. Following management’s formal presentation, instructions will be given for the question-and-answer session. [Operator Instructions]. As a reminder, this conference is being recorded, August 13, 2008.

I would like to now hand over the call to Mr. Ehud Helft of GK Investor Relations. Mr. Ehud, would you like to begin?

Ehud Helft – Investor Relations

Thank you, operator. I would like to welcome all of you to the conference call and thank Cellcom’s management for hosting this call. With us on the call today are Mr. Amos Shapira, the CEO, and Mr. Tal Raz, the CFO. Amos will open the call by providing summary of the main highlights of the quarter, followed by Tal, who will review Cellcom Israel’s financial performance in further detail.

Before I turn over the call 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 Private Securities Litigation Reform Act of 1995 and the Israel 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, 2007 filed with the SEC.

In addition, any projections as to the Company’s future performance represents management’s estimates as of today, August 13, 2008. Cellcom Israel assumes no obligation to update these projections in the future as market conditions change.

You should have all received by now the Company’s press release. If you have not received it please call CCGK Investor Relation at 1-646-787-2866.

I would now like to hand over the call to Amos. Amos?

Amos Shapira – Chief Executive Officer

Thank you, Ehud. Good day everyone and welcome to our second quarter earnings call. We are pleased to another quarter of strong results. In the second quarter of 2008 Cellcom’s revenues, EBITDA, EBITDA margin and operating income reached record levels despite ongoing price erosion and the intense competitive environment in Israeli cellular market. These achievements have been the results of our continuous focus on developing new innovative offering to drive revenue growth while keeping our expenses under tight control.

Our performance in the second quarter continued to be driven by our key growth fundamentals, since the second quarter of 2007, we expanded our market share by leveraging our strong brand and differentiated offering. We improved the quality of our subscriber base by adding more postpaid subscribers, which translated into higher ARPU and we continue to take advantage of our most advanced HSDPA network to expand our 3G subscribers’ base and to grow our 3G value added services revenue.

We also have continued to benefit from the rapid growth of our landline service as we grow them our offering. In addition to assumed strategies to drive top line growth we as well as remain focused on the implementation of ongoing efficiency measures company wide, which is reflected in our industry leading EBITDA margin of 38.6% for the quarter.

Now, to the financial highlights of the quarter, we continue to show strong increase in all our key performance indicators despite the intense competitive environment and the ongoing price erosion resulting mainly from the reduction in interconnect tariffs. In the second quarter revenues were up 9.9% compared to the same period last year reaching NIS1.6 billion, EBITDA in turn was up by 14.7% in the same period to NIS617 million, and net income arose 8.5% to NIS230 million enabling us once again to give back to our shareholders by declaring a quarterly dividend of NIS2.76 per share representing a total dividend of approximately NIS217 million.

On the business front during the second quarter we ended the total approximately 21,000 net subscribers all of which postpaid. In addition we further increased our 3G subscriber base by adding 85,000 subscribers to reach 608,000 all of which postpaid. Our 3G subscriber base now represents 19.5% of our total customer base. At the end of the quarter we continue to lead in terms of number of subscribers with 317 million subscribers.

Turning to our landline services business we continue to see revenue growth from this business as we broadened our service offering by leveraging our next generation network in the business sector.

In summary we are very pleased with our results in the second quarter. I would like to take this opportunity to thank all of our dedicated employees and managers for their efforts and contributions to further strengthen our position as Israel’s leading cellular company.

With that said, I would now like to turn the call over to Tal Raz, our CFO for a detailed review of our financials. Tal, please?

Tal Raz – Chief Financial Officer

Thank you, Amos and good day everyday everybody. Revenues for the second quarter 2008 totaled NIS1.6 billion up 9.9% from NIS1.5 billion in 2007. The rise in revenues was driven by a 6.3% increase in service revenues and a 47% increase in handset and accessories revenues. The increase in service was mainly attributed to the increase in revenues from continued value added services including SMS as well as from the increase in roaming and landline services and was partially offset by the decline in interconnect tariff and ongoing price erosions. The higher handsets and accessories revenues resulted from the increasing number of handset sold in average handset price as we continued to expand our sales of advanced 3G handsets.

Gross profit for the quarter increased 16.6% to NIS781 million up from NIS617 million in the same period. Gross margins for the quarter totaled 48.8%, up from 46% in the same period last year. The improvement in gross margin was driven by increased efficiencies, enhanced purchasing and the stronger shekel against the US dollar.

In addition this quarter following a clarification of the Israel Accounting Standard Board to the International Accounting Standard Number 39, we also recorded one time reversal of rent expenses of approximately NIS40 million. This follows after the accounting rules for embedded derivatives under IFRS, which calls for the separation and reversal of embedded services related to engagements made on or before December 31, 2006.

Our SG&A expenses for the quarter totaled NIS360 million up NIS326 in the same period last year. This includes an acceleration of NIS11 million of share based compensation expenses following a reevaluation of corporate transactions occurrence. As a percent of revenues SG&A totaled 21.9% down from 22.4% in the second quarter of 2007.

Operating profit for the quarter totaled NIS431 million up 26% from the NIS343 million in the second quarter of 2007. Operating margin for the quarter reached 26.9% up from 23.6% in the second quarter last year.

EBITDA for the quarter totaled NIS617 million up 14.7% from NIS538 million in the same period of last year. EBITDA as a percentage of revenue reached 38.6% up from 37%.

Finance expenses for the quarter totaled NIS109 million compared to a NIS19 million in the second quarter of 2007. This increase is the result of interest and CPI linkage expenses resulting mainly from our higher debt level and the increased CPI, which was partially offset by higher interest income on our short term deposit in the absence of our former credit facility, which was fully prepaid last March.

Our financing expenses were also impacted by NIS29 million reversals of interest income of full separation of embedded derivative associated with rent engagement as mentioned before.

Net income for the quarter increased 8.5% reaching NIS230 million or NIS2.36 per share compared to NIS220 million or NIS2.17 per share in the second quarter of 2007.

Now to our cash flow, free cash flow generated in the second quarter totaled NIS308 million up 295% from NIS78 million in the first quarter of 2008 and slightly lower in the NIS363 million in the second quarter last year. Free cash flow for the quarter was substantially high from last quarter following the termination of the majority of payments associated with the preparation for number of portability. Our cash flow from operation in the second quarter totaled NIS457 million compared to NIS452 million last year. Our cash flow for investing activities in the second totaled NIS149 million compared to NIS100 million last year representing 9% of our revenues.

The increase in investment activity attributed mainly to a different dispersal of investments over the year comparing to last year. This together with final payments relating to the preparation for the number of portability resulted in low free cash flow this quarter comparing to the second quarter of 2007. Shareholders equity at the end of June 2008 totaled NIS372 million.

Now to our KPIs. I am pleased to know that despite all the surrounding regulation challenges and competition ARPU for the second quarter 2008 totaled NIS149 up from NIS145 in the first quarter of 2008 and up NIS148 in the second quarter of last year. Average MOU for the quarter was up 1% and 2.6% year-over-year for 361 minutes reflecting an improvement in the facility of our subscriber base.

Moving to our dividends, our Board of Directors declared a dividend of NIS2.76 per share of a total of NIS270 million, as I mentioned in the past our dividend payments are guaranteed and our Board of Directors shall decide at its absolute discretion if and when to declare them.

With that we have completed our business and financial review and I would now like to open the call to your questions. Operator?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, at this we will begin the question and answer session. [Operator instructions]. The question is from Daniel Meron of RBC Capital Markets. Please go ahead.

Daniel Meron

Hi Tal and Amos, congrats on the good execution. Can you give us a sense on how EBITDA margins are, how should we think about it longer term? And then I have follow up question.

Amos Shapira

As you probably understand I am limited to giving you any focus about the future mainly our legal counselor is sitting besides me. So, the only thing that I can say is that we shall continue to work hard on improving our top line and our expense, working on our expenses but I can’t say more than that.

Daniel Meron

So, let me first get to the business front, on the one hand we have got the potential for bundling from [basic] and then Pelephone is going to launch their UMTS network towards the end of the year. Can you give us a sense on how you guys are preparing for that event and what are your thoughts as far as the business implication?

Amos Shapira

As to Pelephone we are in a dynamic environment and in every period we have its own threat and also opportunities. We are very well aware to the development in Pelephone but we take it in consideration, we are preparing ourselves. I think that the fact that Pelephone is upgrading its network not by necessarily is a threat because when there is an improvement and the customers of Pelephone also will be able to enjoy services, it will increase their wellness to these services. I don’t see, as I said by the way before on the portability, I don’t see if Pelephone is rational behavior and until now they have reacted such that they will open in a pack and will make something aggressive because I don’t see this policy as a rational wise, but this is something that I can’t guarantee. As I said, the moment this is the situation in the market and I can tell you that we prepare ourselves to any scenario. Yes, I can’t guarantee that our competitors will continue to be rational, but we prepare ourselves also to irrational behavior.

Daniel Meron

Okay, very good Amos. Thank you so much. Good luck.

Operator

The next question is from [Stan Minneman] of [Extansis]. Please go ahead.

Stan Minneman

Thank you. Congratulations guys. Two questions, one is regarding trade payable days, it’s the decline for another quarter in row. Can you give some color as to what is the reason behind that and should we expect a recovery in payable days and if you can give a little bit information about the gross margins, what’s the reason for the relatively high gross margins for the quarter?

Amos Shapira

Okay, I will start with your last question first. First of all, as you know, and we mentioned it several times in the conference call and in the press releases that we are doing a lot of efficiencies in the company, such as bringing in-house speakerphone technicians, such as doing a lot of improvement in our operation procedure and I think that these days, the quarter, we really see the affect of that on our gross margin. We are also enjoying now the appreciation of the Shekel against the dollar and all of that together improving our operating gross margin overall. Can you repeat your first question again?

Stan Minneman

The first question was regarding trades payables, the decline for second quarter in a row, what is the reason and what do you see recovering in the following quarters?

Amos Shapira

Well, I will of course give you any guidance as to the coming fore quarter, but I can definitely say that if you remember Q4, 2007, in which we had acquired low profit margin because of the preparation for the number portability for sales, we are now actually paying most of the expenses that were related to the preparation for number portability. We see it in quite -- actually in Q1. We see the tail of it in Q2 ‘08, and as I mentioned when I was talking about our free cash flow, these are the tails of the preparation for number portability expenses and hopefully, nobody will explain the market again. So, we would be able to keep and see the same free cash flow numbers, as we used to see in 2007.

Stan Minneman

Okay. Thank you very much.

Operator

The next question is from Al Kabili of Goldman Sachs. Please go ahead.

Al Kabili

Hi, good afternoon. (Inaudible) Israel. Congrats, couple of question. First if you could talk a little bit about roaming revenue and what the potential negative impact could be from Pelephone’s new network?

Amos Shapira

Again, I can’t give you any indication, any specific indication what will be the impact. On the long run, as I said before on the general question not specifically to the roaming, and I said all the time we have the changes in the market and we prepare ourselves and we strengthen our abilities to order to keep our market share in every aspect in the market, and at least I can’t talk about the future. Whether we can learn about our abilities to continue to do it from learning from the past, I leave it to you. But this is our job. There is a competition and we are in a competitive environment and we prepare ourselves as also we are well aware that Pelephone is entering on, so we will have abilities regarding their roaming. But at least in the beginning there is an issue with the handover between the 3G network and CDMA network and so it will take longer until they will be able to have to be an equal player in the inbound roaming. But, it’s a process and we are not standing on the same position as well because we are also developing other capabilities in order to keep our momentum. So, it’s not a dynamic, it’s not a static situation where Pelephone is doing something and we are doing nothing, as you see all the time.

Al Kabili

Okay, thank you. And if you could talk a bit about more about the competitive environment it looks like on the prepaid front, you lost some customers and they are not as profitable but can you talk about what you are seeing on the prepaid front, is this the trend we should expect to continue and is this intentional?

Amos Shapira

Generally speaking about the number of subscribers and their recruitment, finally, we had to look to the numbers and to the revenue. What happened to the revenue, and what happened to the profitability? As we after the number probability when we look at the next number of subscribers of 2007 versus comparing to 2008 so the number of subscribers we increased our market share, this is the end result when you look at the numbers. And also this is supported by the hard numbers of revenue because our growth in revenues was higher than our competition. So, this is effect number two, what we are doing over the time we are looking after the money whether its prepaid customer or postpaid customer yes in average, the ARPU of postpaid customer is higher than the prepaid but there are also good customers in the prepaid. So, what we are looking after is to improving our customer base, because every customer is also generating cost. So, what we are doing, we are working hard in improving our mix of customers and from the end result of number of subscribers and revenue and profit at least something now, it seems that we are playing with all these factors other way.

Al Kabili

Okay. And then, final question is on the dividend, it looks like this quarter, it’s actually above the 95% payout ratio that we’ve seen in the past, can you talk a little bit about that you know how should we be thinking about the dividend going forward?

Amos Shapira

Well, basically I will say again that the dividend policy of the company is to distribute 75% of the net income of the company since we are a public company, since actually third quarter 2007 we are distributing 95% of net income and on top of that we distributed in 2007 or in 2008 based on 2007 result we have distributed a special dividend we shared so that was a return earning of profit from previous year, since this special dividend we had some I would say left over if I can say so on the return earning and then we decided to share our success with our shareholders. And at least, distribute some of this so called left overs to our shareholders as this quarter we distributed 117% of our net income as a dividend, of course, that I cannot give you any further guidance and its all subject to Board discretion as I mentioned before.

Al Kabili

Okay, thanks again.

Amos Shapira

Thank you, Al.

Operator

The next question is Alex Kuznetsov of ING, please go ahead.

Alex Kuznetsov

Good afternoon. Its Alex Kuznetsov from ING, please accept our greetings on strong results reported today. Most of my questions have been answered but, I would like to ask a couple of questions. There is a noticeable reduction in the effective tax rate to 29% in second quarter ‘08 from 35% in the same quarter last year. Could you comment on the reasons for such noticeable decline, please? And secondly, we notice that (inaudible) has fallen by only 1.9% year on year which was offset by MOU expansion, this increase should see better competitive environment going forward?

Tal Raz

To your first question as you know the statutory tax went down in Israel year-over-year, this year is a 27%, which is down from a 29% in 2007. I want to remind you that in 2007 we had some allowance for tax, which dealt with some issues around dividend distribution that was actually vanished over the time. So, this is might be the main differences today, we are in building your business models I think that you should take in to consideration a 27% corporate tax rate, this is a to your first question. To your second question, I think that I would say our best success may be in the last six months is our ability even though we see a price erosion, which is a natural process in this business, we are doing a lot of -- we are actually taking a lot of steps in order to keep the effective tariff as high as possible and I think that if you can compare our results to our competition you can definitely see that we are erasing our RPM less than our competitors. There is some kind, I would say about how to keep tariff as high as possible, but I cannot say any further things about it because I think that this is part of our business.

Alex Kuznetsov

I see.

Amos Shapira

One comment about the price erosion, without saying anything about the future because as we are limited with giving it, when you calculate the price erosion, you divide the ARPU by the MOU and also you have to take the consideration that the ARPU is including the ARPU from SMS and Cancun. So, in fact, that the price erosion is even higher than you see just by dividing the two numbers, if I was understood well.

Alex Kuznetsov

Thank you very much.

Operator

The next question is from Stephen Pettyfer of Merrill Lynch. Please go ahead.

Stephen Pettyfer

Thanks, two question if I could please. First; is on the evolving regulatory environment and given what I believe is news that Ministry of Communications is going to allow full unbundling for Bezeq or maybe force it. I wondered if you could comment on and how you see yourself in that particular business opportunity and if you have indeed any more transparency on the terms of the unbundling process. And then my second question is, just on accounting issue. In your equipment revenue line, do you include in there financial revenues from the installments on handset sales? Thanks.

Tal Raz

The second -- the answer to your second question is, no. To your first question I would let Amos answer.

Amos Shapira

You know, at the moment as long as we understand the decision or the intention of the Ministry of Communication, we didn’t see any concrete change in the policy that creates significant opportunity for us, but we shall continue to examine because it’s not only the issue of unbundling but the issue what would be the prices of any part of the bundle. So, until now what we examined, there was no change and our policy is not just to enter to new territories. We are not after new territory as its own, we are after making money. And at the moment we entered also -- as you see in the past, for example regarding the landline business, we entered only to the business sector because we found it profitable and worthwhile to enter. We didn’t enter, we haven’t entered until now to the private sector because we didn’t think it’s profitable enough. If this change because of -- because the environment will be changed, then we change our strategy, but this is not the case at the moment.

Stephen Pettyfer

Thanks. As a follow up to that one, do you have any idea on timing as to when you will have inside as to whether you can make money from that part of the business?

Tal Raz

It will time because it depend -- I can’t give you a specific timetable because it depends on the Ministry of Communication. You know, only today there was an article in the one of the newspapers about the prices of naked ADSL and Beseq, whether Beseq is following the instruction. It takes times and when it comes to regulations in any ministry I wouldn’t predict anything.

Stephen Pettyfer

Okay, thank you.

Amos Shapira

Thanks Steven.

Operator

The next question is from [Liore Usquaq] of [Merrill Investments]. Please go ahead.

Liore Usquaq

Yes, good afternoon everyone. I wanted to ask as to what degree did the low dollar rate affect your cost efficiency this quarter?

Amos Shapira

Well, I would say that -- let me put it this way. Of course, that when you are talking about a cost of good sold and operating margin, operating profit, as long as we see an appreciation of Shekel against the dollar, we will definitely enjoy this scenario because we will take some advantage on purchasing handsets. Since we didn’t mention the capacity I would say of the influence in number of terms, you can assume that it’s not material. On the other hand of course that in the finance expenses since the company is buying out of it expenses about $300 million in dollar terms here there is some effects but of course, that here we are doing a lot of hedging activity into our Shekel company in order to mitigate the exposure as much as possible.

Liore Usquaq

Any guidelines so as to how I can calculate this?

Amos Shapira

We don’t give any guidelines on this.

Liore Usquaq

Okay. Well, thank you very much then.

Amos Shapira

Thank you.

Operator

The next question is from Johnson Ho of William Blair. Please go ahead.

Johnson Ho

Good morning, great results guys. With regard to the churn did they come in mind with your excavations and how should we sort of think about the churn level on the sustainment basis going forward?

Tal Raz

Again, I apologize that I have to say it again you know, that I can’t give you any indication about the future. As our President said in the past we all know how to explain the past nobody knows about the future. But, saying about these, what we saw coming from the number portability is that churn rate increased and the first quarter was higher churn rate but it declined the first quarter from 5.3% to 4.6%, we are -- churn rate is one of the items that our focus on is the highest. So, we are working on this all the time I can’t guarantee that this trend will continue. But in any case you know this is in our -- to remind you that we are very conservative in this methodology of how to repay to that on our customers. As we didn’t use the methodology of erasing you know customers but we are doing it by quarterly churn. So, this is the best that I can say regarding this. I can maybe fair to you only about on our subscribers market share and also our revenue market share. Since we increased our revenue in -- increase in revenue was the highest in the industry so we increased our market share in revenue market share. And also, when you compare our number of subscribers in the end of the second quarter to the number of subscribers in the second quarter of 2008 due to the parallel period of 2007, then again you see that will increase our market share in subscriber terms. As I said we look to the numbers and see our revenue this is the best.

Johnson Ho

Great. In terms of the handset purchasing efficiency you guys have shown sort of sequential improvement over the half year or so how much more room do you think there is on that side and you know, can you give us a little bit of color in terms of what these purchasing efficiencies are?

Tal Raz

Generally speaking I would say that if I say that there is no room for improvement then his is the time to retire. So, I would never say that there is no room for improvement this is exactly one of the terms, I discussed in one of our conference calls that we have a weekly what we call combustion on efficiency matters. So, and of course, you know, dealing with the cost of our handset is one of the major items that we are working on. This is not only the terms that we are buying, for that we are buying handset but also the number of handset that is on our shelves in every period of time because one of the cost is the cost of maintaining of course, it’s a nice thing to have a wide as possible number of handsets the variety on the shelf but these costs money, so we always examine that the demand in the market and versus that the cost of maintaining wide number of handset. This is another aspect of this issue and another aspect is of course the inventory in days that we and then I can tell you that we have a tremendous success in these terms because we have rather high inventory when we prepared ourselves to number portability and we had a very good success in reducing the inventory from the end of 2007 to this period. So, this was a good operation in our system.

Johnson Ho

Great, thank you.

Operator

[Operator Instructions]. There are no further questions at this time. Mr. Shapira would you like make your concluding statement?

Amos Shapira

Yes. Thank you, everybody for joining Cellcom Israel second quarter and 2008 earnings conference call. We have interesting time ahead and I look forward to hosting you again at our next call. Good day.

Operator

Thank you. This concludes the Cellcom Israel Ltd second quarter 2008 results conference call. Thank you for participation. You may go ahead and disconnect.

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