By Imari Love
As we approach 2013, we took a quick trip around the telecom world and are offering our resulting updates on and insights into the current state of affairs in Canada, Russia, Brazil, and Mexico. After analyzing the economic, regulatory, and competitive landscapes in those countries, a few clear themes were evident. First, as penetration rates rise, mobile termination rates fall, and subscriber growth prospects wane, carriers around the world are slowly downshifting into a more rational and economically efficient mind-set. Second, governments around the world have become increasingly concerned about prioritizing the network quality for wireless services. Third, economic moats matter. Firms like Rogers Communications (RCI), America Movil (AMX), and Mobile TeleSystems (MBT), with economies of scale, financial flexibility, and superior infrastructure, are the one that offer investors the sector's best prospects for return on investment.
Canada: Close to Consolidation
The regulatory landscape in Canada has been relatively benign of late. The rule methodology for next year's spectrum auction has largely been determined, although there will probably be a few tweaks made over the next couple of months. It's clear that each region will have four 700-megahertz spectrum blocks available, which essentially means there will be room for only one new entrant (to offer high-end service) in any given area. We find it hard to believe that new entrants will be able to remain as fragmented as they currently are, and it seems as if the firms are waiting each other out to see who runs out of cash first. Although the major incumbents aren't allowed to buy out the new entrants until 2014, we wouldn't be surprised to see some mergers and acquisitions over the next year, with Wind taking out Mobilicity the most likely scenario.
While the fourth quarter is seasonally the toughest on carrier profitability, the fourth-quarter dips we have seen over the past couple of years were aided by the launches of the iPhone 4 and the iPhone 4S, respectively. The iPhone 5 launched in Canada on Sept. 21, thus we expect the fourth-quarter average margin per user to fall once again. That said, we are encouraged by trends of higher lows for those aforementioned dips, and despite what should be strong pent-up demand for the new device, we expect the fourth-quarter AMPU trajectory to continue upward. Subsidies are starting to stabilize, and retention discounts are becoming less prevalent.
Looking to 2013, consolidation is probably on its way within a year, which should improve the prospects for margin expansion. The good news is that churn is improving across the sector, in part because of the growth in customer willingness to take longer-term contracts (smartphone churn is obviously significantly better than non-smartphone churn). Even better, now the carriers are shifting their collective efforts toward upselling their smartphone customers who do not have a data plan attached to their existing contracts. As consolidation begins, we continue to believe Rogers Communications is the best long-term way to play Canada, given its heightened mobile exposure, smartphone penetration, and network quality.
Latin America: Competition Rising in Mexico, Possibly Easing in Brazil
In July, Anatel suspended America Movil's Brazilian subsidiary Claro, Oi, and TIM Brasil from selling new contracts in certain regions in an effort to improve the level of Brazil's network quality. Anatel gave the firms one month to create action plans on how to solve their infrastructure inadequacies. While Anatel ended up lifting the ban two weeks later, it's clear that the regulator is turning up the heat on the carriers as it braces itself for what is projected to be an overwhelming amount of data traffic demand when Brazil hosts the 2014 World Cup and 2016 Summer Olympics. This comes in the wake of Telecom Minister Paulo Bernardo's mandate in May that the carriers raise their investment spending more than 40%. Anatel also continues to trim mobile termination rates. After a rate cut of more than 10% in February, it is now proposing cuts of more than 20% per year through 2015.
Last year in Mexico, telecom regulator Cofetel cut mobile termination rates by roughly 60%. When we also consider the change of the billing dynamics (customers are now being billed on a per-second basis versus billing that was previously being rounded up to the next minute), the effective MTR reduction was closer to 70%. Mexico is the first country to cut MTR rates with penetration rates less than 100% -- making the cuts not only too big, but also too early. Cofetel's decision, which was supposedly made to level the competitive playing field, has backfired, as the cuts have only widened the profitability gap between America Movil and its peers.
While rectifying this could be a painful process, we expect Cofetel to either raise mobile termination rates again (by changing the assumptions in its underlying pricing model) or promise no further cuts for the foreseeable future. It could also try to set specific prices for each carrier's network, although we doubt that approach would ever be able to satisfy the entire sector.
In Brazil, the changes in the regulatory framework have definitely bled into the competitive landscape, as the carriers have been a bit less aggressive with their SIM card promotional offerings of late in order to focus on improving network efficiency. That's good news as margins have been declining across the board. The aforementioned mobile termination rate cuts, a choppy economic backdrop, and aggressive promotional activity have all conspired to weaken the industry's profitability. We believe, however, that margins should turn around in 2013 as the firms restructure their commission strategy frameworks and realize the integration synergies from their respective mergers. That said, we'll be keeping an eye on Oi, as it represents a potential X factor for the market. After being largely dormant for the past six years, the firm is trying to turn itself around in the effort to reach its aggressive 2015 targets. Oi has ramped up its postpaid promotional activity, so if any firm is going to derail our thesis of improved profitability next year, it is this one.
In Mexico, competition is definitely heating up as marketing expenses have been on the rise thanks to greater subsidies on smartphones. Through the first half of the year, America Movil's EBITDA margin in Mexico was down 340 basis points year over year (to 45.5%). The near-term prospects don't look much better, with NII Holdings recently making its long-awaited 3G launch, and Iusacell now receiving cash injections from its new deep-pocketed parent, Televisa. However, America Movil's scale economies allow it to hold its margins stable amid a turbulent operational backdrop.
Over the past few years, virtually every mobile carrier in Latin America has made a fixed-line acquisition with the hopes of building synergistic value through network integration. America Movil has been arguably the most aggressive of the bunch, acquiring both the biggest cable company in Brazil (Net Servicos) and the largest fixed-line firm in Mexico (Telmex). These acquisitions, coupled with its already dominant scale in wireless, strong financial flexibility, and attractive valuation, give America Movil the best return on investment prospects in the region.
Russia: Two Compelling Options, but Mobile TeleSystems the Cleaner One
The regulatory environment in Russia's telecom industry remains relatively benign and operator-friendly. The mild mobile termination rate scheme that was established six years ago has remained in place despite some talk of cuts earlier in the year. Recently appointed communications minister Nikolay Nikiforov hasn't wanted to ruffle any feathers, but he's made it clear that the number-one priority needs to be improving network quality in the effort to build a sustainable foundation for long-term growth.
The one piece of legislation that has raised eyebrows was done through the Russian Federal Antimonopoly Service) in late May when it delivered an injunction on VIP, banning the firm from making dividend payments. The injunction order basically states foreign ownership restriction laws had been breached. However, with Altimo (VimpelCom's majority shareholder) acquiring an additional 124 million shares last month from Bertofan, the stage may be set for a share conversion that could ultimately resolve the matter. That said, while we believe the dividend will eventually get paid, it might not be by year-end. If the ban is lifted, the first phase would be to pay the final portion of the 2011 dividend ($0.35 per share).
With the shareholder dispute between Telenor and Altimo seemingly headed in the right direction, and the wheels being put in motion for a sale of Algerian unit Djezzy, the market's focus is starting to shift back toward VimpelCom's operational performance in its home base of Russia. While the merger with Wind radically diversified its footprint, Russia -- which contributes roughly 40% of the group's revenue and EBITDA -- is still by far the firm's most important market. The firm was able to regain market share last year, after a couple of years of decline. Now that its share has stabilized, we expect management to focus on improving gross margins by stimulating on-net traffic and optimizing the product portfolio. VimpelCom has cut its prices to become more competitive, but is still on average more than 20% more expensive than its peers (versus 40% previously). This has contributed to the firm being unable to stop its churn rate from rising. In fact, VimpelCom's Russian mobile churn rate has risen on a year-over-year basis in 17 consecutive quarters. The firm has had better luck turning around its margins. It has generated strong savings from its dealer cost base after moving to a revenue-based commission scheme (from a fixed-fee scheme previously) and looks to be ahead of schedule in delivering on the RUB 5 billion in synergy savings it forecast for 2012.
Mobile TeleSystems' new management team has refocused its strategy around higher-value subscribers, which has helped its average revenue per user rebound to 2009 levels. The better subscriber mix, combined with stronger data traffic and record high voice usage, has helped stabilize the firm's margins, which had been eroding over the past few years. We believe the recent margin improvements are sustainable, given the transition to revenue-sharing models for dealer commissions, the introduction of more sensible tariff plans, and the increased centralization of procurement through infrastructure-sharing agreements and outsourcing of network maintenance. All of this should flow down to the bottom line and make the firm more economically efficient. Unlike at VimpelCom, Mobile TeleSystems has been able to cut its churn rates (down 80 basis points last quarter to 10.5%) thanks to an increased focus on smartphone sales and funneling more activity through its proprietary retail chain. Given this superior margin and churn performance and the lack of outside issues that are clouding its story, we believe Mobile TeleSystems is a more compelling play on Russia than VimpelCom.
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