The Israeli Telecom Meltdown

Includes: BCOM, CEL, PTNR
by: Ron Sommer

The four Israeli telecom companies we follow are down an average of 76.75% from their 52 week highs and 84.5% off their five year highs. Does this meltdown represent an opportunity? The high share prices enjoyed by telecom companies were due, in large part, to the monopolist practices of several companies and a "bubble" that was created around them.

In the not too distant past, Israel's telecom industry consisted of one company, Bezeq Israeli Telecommunications Co. Ltd (TASE: BEZQ). Back in the day, Bezeq was so inefficient that customers waited for as long as eight years to get a residential telephone line installed and then paid exploitative prices for the service.

Eventually, with the advent of cell phones, competition came to the market. At one time there were seven telecom companies vying for a market with a total population of less than eight million people. Eventually, the government cut the number of competing firms down to four. Recently, the market changed again with the introduction of mobile virtual network operators (MVNO)

This month, two new low cost cellphone service providers entered the market with disruptive pricing. Within days, some 20,000 customers dumped their service with the established providers, Pelephone, Orange and Cellcom and jumped to the new arrivals, Golan Telecommunications and Hot Mobile (TASE: HOT). These two new companies are offering an unlimited phone, internet and texting service at very low fixed rates.

Pelephone Communications Ltd, 100% owned by Bezeq, is Israel's first cellular phone operator, with over 2.8 million subscribers, including over 1.3 million subscribers on the new HSPA network. In response to the upstart's initiative, Pelephone announced its own all-included package. Meanwhile, Rami Levy, another new carrier, announced they are developing their own all inclusive package.

Home Cellular is another new wireless communications carrier belonging to a DIY housewares and hardware chain called Home Center. The Rami Levy Communications venture is part of the Rami Levy Hashikma Marketing (TASE: RMLI) supermarket chain. One attraction of these new cellphone outfits is the relative simplicity of obtaining service and easy to understand pricing. The traditional carriers are well known for a profusion of calling plans, negotiable benefits, rebate programs, hidden costs and complex forms. Now, following a rash of regulations in the local cellphone market, users have never had it so good: switching companies while keeping the same number; handsets usable through any provider; and, reduced exit fees. Alon Holdings Blue Square is set to launch its YouPhone service.

Golan Telecom, which uses the Cellcom network, accused the competing traditional carriers of making it difficult for customers to switch carriers. The government intervened and resolved the conflict. On the other hand, Rami Levy Communications approached Golan Telecom and HOT Mobile with an offer to cooperate. Both Golan and HOT threaten MVNO operators such as Rami Levy. The MNVOs are responding faster than the traditional carriers with fixed fees plus payment per minute for calls plans while the new carriers are offering fixed rates for unlimited calls, SMS and internet access. These plans make the MVNOs even more dependent on the price of network services they buy from the traditional carriers.

Alon Holdings Blue Square Israel Ltd (Blue Square) operates in three segments: Supermarkets segment, Non-Food segment and Real Estate segment. In its Supermarkets segment, the company is a food retailer in the State of Israel. In its Non-Food segment, the company sells Non-Food items both in its supermarkets and in retail outlets. In its Real Estate segment, the company owns leases and develops yield-generating commercial properties. As of May 31, 2010, the company had 207 supermarkets with brands, including Mega Bool, Mega in Town, Mega, Shefa Shuk and Eden Teva. In addition, as of May 31, 2010, the company had 268 Non-Food retail outlets (partly through franchisees) under the control of its subsidiary, Bee Group Retail Ltd. (Bee Group) under the brand names Naaman, Vardinon, Sheshet, Kfar Hasha'ashuim, Rav-Kat, Dr. Baby and All for a Dollar. Alon Holdings Blue Square has 700 retail outlets in Israel

The YouPhone business is Israel's cheapest cellular telephone operator. YouPhone launched on May 22 in 43 branches at Dor Alon service stations and Mega supermarkets. The cellular plan is offered to Mega customers who belong to its "You" customer club. The most innovative aspect of YouPhone's pricing plan involves what it calls "minutes that don't cost." Based on customers' spending at Mega supermarkets or Dor Alon gas stations, customers will get free minutes of talk time. The company will also sell cellular telephones, purchasers of which will receive vouchers for use at Mega supermarkets and other retail stores.

Alon is a microcap trading on the New York Stock exchange and is not widely followed. It is also a mishmash of different businesses, making comparisons difficult. What we do know is that the company is profitable and has been over the years. Net income was $37.4 million in FY07 and declined to $12.4 million in 2010. Net income started its recovery and reached $18.2 million in 2011. EPS in 4/11 was ($0.23) compared to ($0.01) in 4Q10. Sales grew to $793.2 million in 4Q11 from $778.6 million in 4Q10 and to $3,257.7 in 2011 from $2,219.3 million in 2010.

The company's five year average P/E is 27X compared to today's 9.5X. Price to book is now 0.54X as compared to its average of 1.85X. Alon carries a heavy debt. On an enterprise value to EBITDA basis, the company is overpriced. Alon has carries an EV/free cash ratio of more than 19X. All considered, we think Alon's market price is still too high. Alon has dropped about 72% from its 52 week high and about 87% from its five year high. We can see the share price drop as low as $1.35.

B Communications Ltd (BCOM), formerly 012 Smile.Communications Ltd, is focused on the telecommunications industry. The company's asset is its controlling interest in Bezeq The Israel Telecommunications Corp. Ltd. (Bezeq), which is a telecommunications group. Bezeq is the principal provider of communications services in Israel, providing a range of telecommunications operations and services, including domestic fixed-line, cellular and international communication services, multi-channel television, satellite broadcasts, Internet services, customer call centers, maintenance and development of communications infrastructures, provision of communications services to other communications providers, television and radio broadcasts, and supply and maintenance of equipment on customer premises, which is referred to as network end point (NEP) services. On April 14, 2010, it acquired 30.44% outstanding shares of Bezeq The Israel Telecommunications Corp. Ltd. (Bezeq).

With B Communications, we get a more traditional telecom company though not a very transparent one. BCOM has the controlling interest in the aforementioned Bezeq which, in turn, owns the cellular provider Pelephone. Pelephone is the host network for Rami Levy Communications.

Until the last decade when Bezeq was owned by the Israeli government, Bezeq had a monopoly on landline telephony and Internet access infrastructure (ADSL VDSL2). Though it remains an important provider of telephone services, it has had competition from the sole cable provider in the country (since September 2006), Hot, which offers a cable-based telephone and internet access services as of 2005, and with 012 Smile and more recently 013 Netvision and Orange.

On May 9, 2005, Bezeq was officially privatized when 30% of its shares were sold by the state to the Apax-Saban-Arkin investment group for $972 million. The cellular communications provider Pelephone is a fully owned subsidiary of Bezeq. Bezeq is also the largest shareholder in D.B.S. Satellite Services (1998) Ltd., known by its trademark name, Yes, the satellite (DBS) television provider in Israel.

In April 2010, the controlling interest in Bezeq, held by the Apax-Saban-Arkin group, was sold to B Communications, a subsidiary of Eurocom Group, for $1.75 billion.

BCOM has grown its sales from $288.8 million in 2007 to $2,977.8 million in 2011. For the quarter ending 12/31/11, sales declined to $693.9 million from the year-ago period of $800.7 million. During the same period, the EPS loss narrowed to ($0.75) from ($1.46). The company has been losing money every year since 2010 and for the last five quarters. The company wallows in debt even though its EV/EBITDA ratio of 3.6X is surprising low. BCOM's EV/FCF is a not too high 9.93X. The company's 52 week high share price is $29.50 so that it is down about 86% from the high and about 89% from its five year high. We think the company is fairly valued at $4.47.

Cellcom Israel Ltd. (CEL) is a provider of cellular communications services in Israel. Cellcom offers a range of cellular services through its cellular networks. These services include basic and advanced cellular telephone services, text and multimedia messaging services and advanced cellular content and data services. As of December 31, 2010, the company also offers international roaming services in 179 countries.

It offers its subscribers a selection of handsets from various global manufacturers, as well as extended warranty and repair and replacement services. It also offers landline transmission and data services to business customers and telecommunications operators and it offers landline telephony services. As of December 31, 2010, the company provided cellular communications services to approximately 3.394 million subscribers, including basic cellular telephony services and value-added services, as well as handset sales. In August 2011, the company acquired Netvision Ltd.

Cellcom recently announced results for 1Q12. The company declared a dividend worth about $0.34 per share (about $1.34 annualized). This dividend amounts to a payout ratio of 75% of net income. Total revenues were $427 million, a 0.1% decrease; EBITDA totaled $128 million, a 25.7% decrease; EBITDA margin down to 30% from 40.3%; operating income decreased by 41.6% to $74 million and net income decreased to by 43.5% to $47 million. Free cash flow decreased to $39 million, a 64.1% decrease.

The company provided some guidance for the remainder of the year. The CEO, Nir Sztern, expects further declines in revenues and profitability as a result of the new competition.

Cellcom appears to have abandoned the light and medium-use segment and refocused its efforts exclusively on smartphone owners and heavy users.

Even without fourth results, we see a company in free fall. Revenues and operating income have fallen since 2010. However, the company is profitable and with a dividend yield of 22% some price support will come from yield hungry investors. On an EV/EBITDA basis, the company appears to be slightly overvalued as compared to the industry median and on the basis of EV/Invested Capital, perhaps significantly overvalued. In spite of the negatives, we cannot see how this company can trade at 5.6X next year's earnings. Ben Graham gave no growth companies a PE multiple of 8X. Applying this metric to Cellcom expected FY13 EPS of $1.30 gives us a fair value estimate of $10.40.

Our last company is Partner Communications (PTNR). Partner is a mobile telephone network operator in Israel. The company's products and services are marketed under the Orange brand. During the year ended December 31, 2009, its global system for mobile communications/universal mobile telecommunications system (GSM/UMTS) network covered over 98% of the Israeli population. Its GSM services include standard and enhanced GSM services, as well as value-added services and products, such as roaming, voice mail, voice messaging, color picture messaging, ringtone and game downloads, information services, and general packet radio services (GPRS), which enables the packet transfer of data. Its third generation (3G) network offers a range of services, such as video calls, a new portal of content services, including a rich selection of video-based services under the orange time sub-brand, and the transmission of data. Partner is controlled by Scailex Corporation (OTCPK:SCIXF).

Orange, formerly Orange plc, is a telecommunications corporation of British origin that became a subsidiary of Mannesmann in 1999 and subsequently, in 2000, of the France Telecom group. Orange is the flagship brand of the France Telecom group for mobile, landline and Internet businesses, with 226 million customers as of December 2011 and, under the brand Orange Business Services, is one of the world leaders in providing telecommunication services to multinational companies.

Partner is an Orange franchisee controlled by Ilan Ben Dov's Scailex. For the first quarter of 2012, the company reported lower profit and revenues. Revenue fell to $423 million and net profit fell to $39 million or $0.25 per share. Partner pared operating costs with a layoff of 1,440 jobs in the past year. The company experienced a 12% drop in average revenue per user and reported losing subscribers in the mobile, telephony and ISP segments. The company's guidance reflected the increase in competition putting pressure on market share and reduced pricing.

Partner has an indicated dividend of $1.17 per share which yields 26.2%. However, with FY 2012 EPS estimates of $0.89 to $0.99 and free cash flow estimated to be $1.92 we would not be surprised to see the dividend suspended.

The company is fighting back to maintain its market share. They launched a new pricing plan called "Clear Unlimited" offering unlimited calls and SMS messages and 500 megabits of internet access at a competitive flat rate. Partner is also launching multi-channel TV services with Comigo Ltd. This platform will enable Partner to compete with HOT Telecommunication Systems (TASE: HOT) and DBS Satellite Services (1998) Ltd (YES), a subsidiary of Bezeq. Comigo provides servers, converters and TV interfaces for smartphones and tablets.

We are comfortable estimating Partner's fair value at about $3.50 per share.

A number of seemingly insurmountable obstacles face the veteran cellphone operators in Israel. They have business models that rely on limited competition and the ability to set high, if not exploitative, pricing for the services they offer. They are slow to adapt and lack the vision needed to move forward in a profitable manner.

The new companies have their own set of problems. Namely, their ability to keep prices low while they build market share by taking customers away from the traditional carriers. To succeed, the new entrants will need to raise prices just to pay the expenses they incur for establishing a network, customer service, financing and other expenses. The offers by Golan telecom and HOT Mobile are putting increased pressure on Home cellular and Rami Levy who cannot match the MVNO pricing plans because of their agreements with the carriers.

These are not the only players in the nascent MVNO market. The following companies have also applied for MVNO licenses in Israel: Caramel Progressive Communications, Cellular Oak, The Israel Postal Company, Ituran, Telecom 365, Perry Telecom, T2T Communication, Marathon 018, Azi Communications, among others.

Competition in the telecom sector in Israel is a good thing but not without consequences. The shares of telecommunications collapsed in response to the rising competition. The next chapter in this saga is not written. The market will eventually stabilize and prices for the products being offered by these companies will rise. The open question now is at what pace will the new carriers recruit subscribers and the loss of subscribers by the veteran carriers. We believe the veteran carriers will see continued subscriber losses.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.