Millicom International Cellular (OTCPK:MIICF) is a telecommunications and media company that provides mobile, digital, and broadband and pay TV services, as well as mobile financial services to governments, multinationals, corporations, and small and medium sized businesses in Central America, South America, and Africa. Millicom is the largest wireless operator in El Salvador, Guatemala, Honduras, Paraguay, and Chad, and is among the market leaders in the other countries in which it competes. Despite strong underlying performance, currency headwinds and broad-based economic weakness are depressing valuations. These pressures will continue to weigh on growth in the short term, but if investors are patient we believe a lucrative opportunity exists thanks to a combination of healthy long-term growth catalysts and margin upside potential.
Millicom generates 85% of its revenue in Latin America and 15% in Africa. The company has largely been able to avoid competing against the major telecoms firms America Movil (NYSE:AMX) and Telfonica (NYSE:TEF) by focusing on "smaller and more out-of-the-way countries than its larger peers" (Morningstar Analyst Report). Millicom's focus on niche markets has helped the firm establish leading positions in these countries, allowing it to earn high returns on capital. Over the past ten years, MIICF has averaged a ROIC in excess of 20%. Barriers to entry in most of Millicom's markets are high, thanks to the combination of relatively small populations (which limits the addressable market), high market penetration, significant capital requirements, and Millicom's scale, which provides an important cost advantage. Thus, MIICF has a formidable position in most of its markets. But, with wireless services reaching the point of saturation in these counties, the question surrounding Millicom now is whether it can find new ways to grow.
Millicom has averaged annual revenue growth of 11.4% over the past five years. While the company is still for better or worse a wireless-only operator in Africa, Millicom has expanded its services in the mature Latin America markets to include pay TV, broadband, and financial services. These packaged offerings, which provide some compelling cross-selling opportunities, have helped the firm add customers and offset slower subscription growth on its mobile networks. Looking forward, we see a number of catalysts that should continue to spur growth, including increased data usage and exposure to Africa. Millicom's Africa operations include Chad, Ghana, Rwanda, Senegal, and Tanzania. Because wireless penetration rates in these countries are considerably lower than in Latin America, the potential for new subscriber growth is much higher. While higher levels of competition in these markets (Millicom typically competes with more than five telecoms firms in each country) means the firm earns lower returns compared to Latin America, there is potential for margin expansion. The industry is still in its growth phase, so operators are focusing on developing infrastructure and acquiring customers. As Millicom builds scale, we expect the firm to unlock value through cost cuts.
Millicom currently trades at the midpoint of its 52-week range, with a dividend yield of 4.4%, a P/B of 1.7, and a P/S of 1. The cash flow yield of 25% is impressive, and a testament to the company's efficient scale and cost advantages that allow it convert a high percentage of sales into free cash flow, despite heavy capex. We believe that currency headwinds and subdued short-term growth expectations are responsible for the low valuation. Last year the Columbian peso depreciated 41% against the US dollar, masking what was otherwise a solid year for the company (7.4% organic revenue growth). Weakness in developing and emerging market economies continues to weigh on growth, as handset sales and cable TV revenues came up short of expectations in the latest quarter. Currency headwinds will likely cause reported revenue growth to be negative for FY16, but we expect growth to return to positive territory in 2017 and beyond. For the forecast period we project average annual revenue growth in the mid single digits, driven by increased data usage, a rise in pay TV subscriptions in Latin America, and wireless subscription growth in Africa. But the real value proposition with Millicom relates to the margin upside potential. We believe that greater scale, cost-cutting initiatives, and the moderation of one-time expense items and acquisition-related charges will drive operating margin back to the firm's five-year median of 14.5% within the next few years, up from the current level of 11.2%.
We like Millicom for a number of reasons. The company has important competitive advantages in all of its markets, and stands to gain from increased mobile penetration and data usage in developing economies. Millicom's exposure to these markets currently weighs on its valuation, as weak growth and currency fluctuations have sent investors heading for the exits. But these pressures will subside, and when they do the market will become more appreciative of Millicom's strong underlying fundamentals. Assuming operating margin recovers to its long-term average (a conservative assumption in our opinion), earnings will grow roughly ten percent annually over the forecast period. For investors looking to diversify outside the US, MIICF is an attractive option.
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