Since all the 'Big Three' telecom operators of Russia (Mobile TeleSystems (NYSE:MBT), MegaFon and VimpelCom (NASDAQ:VIP)(OTC:VMPLY)) have published their IFRS 2015, I think it is the best time to talk about the entire Russian telecom sector and understand what ideas and trends can come up in 2016. You are probably familiar with MBT and VimpelCom, while MegaFon and Tele2 (OTCPK:TLTZF) Russia haven't been presented on SA yet.
Some of the most serious problems in the Russian economy are monopolization of some sectors and excessive presence of state in the share capital structure of the largest companies. As a result, such monopolies distribute their resources quite inefficiently. For example, Gazprom (OTCQX:GZPFY) and RZD can afford unreasonable capital-intensive projects with NPV <0, support sports teams, pay high bonuses to top management, throw corporate parties (which are surrounded by legends and anecdotes), etc. In this regard, the telecom sector stands out: only the fourth federal operator Tele2 is the subsidiary of the state's Rostelecom and VTB; until 2014, the company belonged to private shareholders.
The high competition in this sector demands serious CAPEX from telecom companies; however, one ruble spent becomes several rubles earned. This is just that kind of story: you have to run for dear life to stay in place, but to move forward you have to run even faster.
Results of 2015
First of all let's make it clear: I've focused on the Russian market because Mobile TeleSystems gets almost 90% of revenue from there, Megafon - 98% and Tele2 - 100%. Only VimpelCom is a globally diversified company and gets just 48% of its revenue from Russia.
According to the 2015 results, the market shares of operators in the Russian cellular market are allocated as follows:
Note that in general, leaders of the Russian telecom sector met their initial growth forecasts for 2015:
- MBT predicted a growth in consolidated revenue of about 3% (it finally turned out to be 5% growth).
- MegaFon was a little bit more modest at 0% (turned out to reach 0.4%).
As far as I know, VimpelCom didn't make any growth forecasts for the Russian segment. However, it was announced that the company would focus on cost optimization. VimpelCom had greatly increased its debt, lost a part of its share in the Russian market and is now engaged in consolidating its business and cleaning out the Augean stables (I wrote about it in my article, VimpelCom: 2016 - A Year Of Big Plans And Hopes). The company has started saving a lot: it has reduced the staff, outsourced a part of the operational processes, and sold cellular towers. At the end of 2015, the CEO of VimpelCom, Mr. Slobodin, even mentioned that company was looking for a new place for its central office because the current office was too expensive.
MBT, on the contrary, has focused on increasing CAPEX. Although the company is a leader in the Russian market now, it thinks that reasonable implementation of investment programs during the crisis will make a good foundation for the future. The same strategy was used by MegaFon during the crisis of 2008-2009. As a result of VimpelCom showing more interest in global expansion and saving on CAPEX in Russia, MegaFon was able to overtake it and became the second largest Russian federal operator.
Why MBT tried to focus precisely on growth?
One of the reasons was the collapse of the deal to purchase a communication salons network, Svyaznoy, which forced MBT to increase its retail trade. The deal, which managed to be approved by the Federal Antimonopoly Service, did not take place due to the house arrest of Vladimir Yevtushenko, owner of MBT's main shareholder AFK Sistema. As a result, Svyaznoy went to the Solvers Group, owned by Mr. Malis, who is the younger brother of the CEO of Euroset - the other large network of communication salons. And Euroset is on an equal footing owned by MegaFon and VimpelCom. Now there are rumors that Svyaznoy and Euroset plan to merge, which means that MBT has nothing to catch there.
As a result, MBT had to focus on building its own retail network, which in 2015 rose to 5,166 stores (+22%) and generated RUB 40.3 billion of revenue (+37.4% year to year).
MegaFon is the second largest player by revenue in the Russian market. The company operates in 83 constituent entities of the Russian Federation, Tajikistan and in Abkhazia and South Ossetia. The number of mobile subscribers at the end of 2015 amounted to 74.8 million people, which is only 2.5 million less than that of MBT.
56.32% of the company belongs to USM Group (Alisher Usmanov), 25.17% to TeliaSonera, and 3.92% to MegaFon Investments (Cyprus) Limited (subsidiary of MegaFon). The free float is 14.59% of the company.
From the point of view of the financial profile, MegaFon is a strong representative of the telecommunications sector. Despite the fall in revenue due to a crisis in the Russian economy and increasing competition in Moscow, the company demonstrates an enviable stability.
Financial results of MegaFon year to year (RUB mln)
The foundation of the MegaFon business is formed by mobile communication services - 86%. 7.5% is fixed-line services and 6.4% is left for the sale of accessories and equipment. During 2015, MegaFon generated RUB 313 billion of revenue, RUB 132 billion of OIBDA, while profitability equaled to 42%. The dynamics of financial indicators is similar to MBT; the only difference is that MegaFon holds a higher profitability (mainly due to the focus on the high-margin Russian market).
MegaFon as well as MBT consistently pay good dividends. MegaFon tries to allocate at least 50% of net profit to payment of dividends (according to the dividend policy), but due to high the FCF it actually pays more. The dividend yield of the shares stays in the region of 7-9%, which is comparable to MBT's.
The ratio of net debt/OIBDA is 1.37 and the interest coverage ratio is more than 10, i.e. the credit profile is very strong and stable. It's worth noting that while Tele2 carries high costs due to its expansion and worsens its credit metrics, and MBT and VimpelCom are involved in lawsuits in Uzbekistan (which promises them serious penalties), MegaFon has no such risks.
Overall. I want to mention that the investment funds in the Russian stock market consider MBT and MegaFon as peers (like Verizon (NYSE:VZ) and AT&T (NYSE:T), for example), so they include both stocks in their portfolios.
Tele2 is the fourth federal Russian cellular operator with a market share of 15%. 45% of the company belongs to the state company Rostelecom, while the remaining 55% are divided between VTB Group, Mr. Mordashov (known as the owner of Severstal) and Bank Rossiya. The company was established by the Swedish group Tele2 AB (OTCPK:TLTZF) in 2001, and in 2014, it was sold to current shareholders.
Among the federal cellular operators, Tele2 seems to be the weakest player according to financial indicators. As the company didn't provide annual accounts, I'll handle the figures for the first 9 months of 2015.
Over the past two years, due to the focus on the active expansion of its market share, the company has significantly worsened its debt profile. Against the background of active borrowing, its net debt has increased from RUB 29 billion in 2013 to RUB 92 billion at the end of 3Q 2015. For the same period, OIBDA has increased only slightly. As a result, the net debt/OIBDA has increased from 1.2 at the end of 2013 to 3.76 at the end of 3Q 2015, and the ratio of OIBDA/interest cost decreased from a comfortable 5.11 to 2.65.
Such negative dynamics of the company's debt is explained primarily by large-scale investment programs. The company is actively investing in the expansion of 3G and 4G networks, as well as entering new regions. Before working with Rostelecom, Tele2 had been presented in 43 regions of Russia, and over the past eighteen months, it entered 22 more. The company directs 38% of revenue to the capital costs, which is almost two times higher than MBT, MegaFon and VimpelCom.
Also, debt of an operator increases when it aims at expanding its market share. At the end of 3Q 2015, the company had 35.5 million subscribers. At the end of 2015, Tele2 was targeting 10% of the Moscow market, which generates about 30-40% of revenue for the 'Big Three' operators. You may have noticed that the company's plans are rather ambitious. But an active advertising campaign and a policy of low prices do find a recall from some Moscow residents. Obviously, the "Big Three" aren't going to give up their share to Tele2 so easily. They have also revised their tariffs. It is too early to draw conclusions about the success or failure of this program, but so far things for Tele2 are not as successful as it was planned.
The company's revenue for the first 9 months of 2015 amounted to RUB 70.5 billion, which is 13% higher than a year ago. It is obvious that in the pursuit of growth, you have to sacrifice investment returns. OIBDA margin at the end of 3Q 2015 amounted to just 26% and an annual result will probably be even less. This is the weakest result in the sector. The 'Big Three' keeps this indicator higher than 40%. Also, Tele2 is the only one in the sector that will receive a net loss for the year: RUB 4.6 billion for the first 9 months of 2015 and RUB 7.8 billion for the year (estimated by Rostelecom).
Financial results of Tele2 year to year (RUB mln)
It is interesting that current shareholders of Tele2 are actively looking for someone to sell their shares. After all, the company's business is very capital-intensive, and there is no income to be expected in the coming years. At the end of 2015, information appeared that representatives of VimpelCom Ltd. and Tele2 shareholders discussed the possibility of merging the two companies. However, negotiations are suspended for now.
The company itself is non-public, so we only have the consolidated reporting data for the last three years. A key competitive advantage of Tele2 is the presence of a strong shareholder, VTB. At the expense of VTB, Tele2 can afford to attract credit resources and finance its growth. The big question is, how will Tele2 be able to sustain this growth in economic stagnation conditions. Therefore, I expect that in 2017-2018, the company will have to start focusing on increasing the business margins and maintaining a less aggressive pricing policy.
Expectations for 2016
In its press release, initiated by publishing financial statements for 2015, MegaFon writes:
"We expect increased competition on the Russian market, along with the further weakening of the macroeconomic situation in 2016. With this in mind, we expect a slight increase in revenue, and the OIBDA indicator to be within 120-126 billion RUB. Taking into account the current weakening of the ruble, we expect that in 2016 CAPEX will amount to 75 bln RUB."
The forecast of falling for 5-9.5% OIBDA has triggered the drop in MegaFon's shares of 4.5%. Such a forecast is quite negative; however, the management of MegaFon always provide restrained forecasts. In 2013 and 2014, MegaFon guided for RUB 64.51 per share, in 2015, it was RUB 80.64 per share. As for me, I expect that despite the conservative forecasts this year, dividends can amount to not less than RUB 64.5 per share.
MBT, on the contrary, is more optimistic: revenue growth of 4%, change in OIBDA from -2% to + 1%, and CAPEX in the amount of RUB 85 billion. The market generally has reacted to the company's forecast with optimism; the information about upcoming dividends will be announced in April. There is no clarity about the investigation in Uzbekistan, but according to my estimates, in the worst case, MBT will increase the debt burden, but try not to reduce the dividends.
VimpelCom expects revenue and EBITDA for 2016 to be at or slightly below the level of 2015. CAPEX will remain at the level of 17-18% of revenue. In general, this year for the company is going to be very eventful, as large-scale reorganization of the company and sale of low-margin assets are planned to happen.
One of the main activities of a company in the telecommunications sector would be the sale of cell towers. This has already been stated by VimpelCom Ltd., MegaFon and Tele2. MBT keeps aloof yet, but I'm sure that it will be forced to follow its competitors. Most likely, the sale will be made to Russian Towers, a company whose core business is building and leasing of cellular towers. In case of a sale of the towers, all the parties will be able to win: the operators will save on capital costs and maintenance of tower infrastructure in addition to receiving money from the sale, and Russian Towers will be able to rent each tower not to one but to 3-4 customers at once, that will enhance its profitability.
After this study, I came to the conclusion that every company can be interesting to buy in its own way.
In the table below are the basic financial data of the companies and their multiples:
Since the main revenue that the companies generate are from Russia, the data is in RUB million. Market capitalization of MBT is counted on the basis of evaluation of the shares on the Moscow Exchange at the rate of RUB 240 per share. Local MBT shares are now trading at a discount to the ADR at the NYSE by 12%, so perhaps multiples will seem quite undervalued to you.
In relation to MegaFon, MBT has a discount that I associate with the risk of getting a fine in the Uzbekistan case as well as precipitate of the lawsuit against Vladimir Yevtushenko, who is the majority shareholder of MBT through Sistema. As for the rest, the two companies are almost identical, so both are interesting only in terms of dividends.
Since the shares of MegaFon are not available for purchase on the US stock exchanges, the choice can be made only in favor of MBT. But as I said earlier, in spite of a pretty good dividend yield, currency risk is still not going away. You can buy a great company with an excellent dividend yield at great multiples, but still suffer losses due to the devaluation of the ruble. Unfortunately for shareholders, MBT can't shift the currency risk to its clients (at least in the short term), and therefore, these risks will be borne by the shareholders.
In my article, VimpelCom: 2016 - A Year Of Big Plans And Hopes, I have concluded that it is necessary to wait until VimpelCom begins to solve its problems with debt and a huge number of scattered assets. But now in the process of additional research, I came to the conclusion that only a successful reorganization would allow the company to increase its capitalization. The penalty for the company's activities in Uzbekistan is already taken into account in the price, but there are some concerns about the successful closing of the merger of Wind Telecomunicazioni and Telecom3 Italia in Italy and the merger of Mobilink (a subsidiary of VimpelCom Ltd.) and Warid (Dhabi Group) in Pakistan.
Although the indicator net debt/EBITDA is in the amount of 1.45 (in the table), taking into account the Wind Telecomunicazioni debt, the figure really is 2.9. Now that VimpelCom's management is focused on reducing the debt burden, in 2016 and 2017, the company will live in austerity mode. At the end of 2016, the management of the company expects the growth of net debt to 2.0. The company doesn't plan to pay dividends until it is able to reduce the net debt/EBITDA ratio to 1.4-1.5, and I expect that to happen not earlier than 2H 2017-1H 2018.
But here is an idea: in the case it reduces net debt and starts paying dividends, it is logical that there will be a revaluation of the company to a level of its Russian counterparts. I expect that in this case, VimpelCom will be traded at par with its Russian competitors, i.e. at least at a rate of 1.0-1.2 by multiplier P/Sales. The EV/EBITDA multiplier remains unchanged due to the increase in equity shares and decrease of net debt. On this basis, I see the target price for shares of VimpelCom Ltd. in the amount of $6-7.2, which represents an upside potential of 50%-80% in the horizon of 2-2.5 years.
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