Mobile TeleSystems Is the Most Compelling Investment Case in Russian Telecom
Despite economic headwinds, MTS' narrow moat and network/distribution advantages give it a clear edge over VimpelCom.
Despite economic headwinds and recent share-price pressure, we believe the Russian telecom sector still offers a long-term opportunity to invest in relatively undervalued, well-run companies with solid free cash flow and impressive returns on invested capital. Mobile TeleSystems (MBT), known as MTS, and VimpelCom (VIP) continue to expand their respective mobile subscriber bases in Russia by leveraging their economic moats to drive customer loyalty and boost minutes of use, or MOU. Better yet, some of the key economic indicators have begun to stabilize, and the regulatory landscape is benign. Ultimately, we believe Mobile TeleSystems is best positioned to further leverage its brand strength and network infrastructure advantages throughout Russia and the Commonwealth of Independent States. Our view is supported by MTS’ superior top-line prospects, stronger free cash flow yield, and higher returns on invested capital.
Russian Economy Looks to Be a Near-Term Headwind
With GDP growth decelerating in Russia and inflation running higher than the target range, the economy seems to be a near-term headwind for the telecommunications sector. Economic growth has slowed for six straight quarters in part because of a secular decline in OECD oil demand. In fact, the International Monetary Fund recently cut its 2013 and 2014 growth projections for Russia by 100 basis points and 80 basis points, to 1.5% and 3%, respectively. While the Bank of Russia is targeting an inflation range of 5%-6%, the actual rate has been at more than 6% for the past year. The combination of slower growth and higher prices has weighed on consumer confidence, which has been negative for more than four years. It has also weighed on real disposable income, which is now 33% lower than the OECD average. Unemployment nationwide is also up slightly (10 basis points to 5.3%) from the year-ago period, though this number in isolation can be deceiving. For example, unemployment rates in Moscow and St. Petersburg have been reported to be less than 2%, while in some of the outer regions, it’s been as high as 45%. The key interest rate has held steady at 5.5% for the past year, a trend we expect to continue given the heightened inflation, limited gross domestic product growth, and lackluster employment gains.
One thing that could help ease inflationary pressure is the proposed 2014 freeze on regulated-price growth for power, gas, and rail monopolies. While we are skeptical that it will be pushed through, given the political power these energy companies garner, if the mandate is approved, it could have the dual effect of lowering inflation and boosting growth. The freeze could drop the inflation rate to the middle of the Bank of Russia’s target range. The Russian economy needs all the help it can get given that the third-quarter growth of only 1.2% was the worst quarterly result in more than three years. Looking ahead, we expect GDP growth to steadily rise as inflation abates over the next couple of years. Ideally, this could lead to disposable income rising faster than inflation, which has not happened since 2011. As disposable income rises, we assume discretionary telecom spending will increase, which should translate into profitability gains for the wireless carriers.
We Believe the Long-Term Impact of Mobile Number Portability Will Be Negligible
After years of debate and government infighting, Communications and Mass Media Minister Nikolai Nikiforov has finally approved the introduction of mobile number portability, or MNP. On Dec. 1, 2013, MNP was partially introduced, allowing subscribers to change carriers while maintaining their current phone numbers. However, because of a lack of testing, the service won’t be fully functional until mid-2014, and the subscribers who choose to port their numbers could have a difficult time doing so in the meantime. Currently, only a limited number of users per day are allowed to port during this initial launch, and we believe the near-term impact will be negligible.
Looking ahead, once number portability becomes more widely available, churn will inevitably rise (slightly) from today's levels (MTS had a churn rate of only 9.1% last quarter--a multiyear low), but we don’t believe it will be a meaningful shift. Because the stickier corporate market (roughly 10% of the subscriber base) has become a bigger piece of each firm’s subscriber base and because of its strong network quality and recent smartphone proliferation, we doubt that MTS will return to its 2011 peak churn level of 12%. VimpelCom, however, could easily slip back to its 2012 churn level of 16% if it doesn’t improve its network infrastructure quickly. In fact, given its network superiority, MTS could actually benefit from number portability if it’s able to steal customers away from VimpelCom. In the first six weeks of the launch, MTS has posted a net gain of subscribers who have ported. In the long run, history shows that number portability has a negligible effect on long-term churn rates. In the U.S., for example, when MNP was introduced in late 2003, the competitive backdrop was far more intense (with six players compared with three today in Russia) and the U.S. penetration rate was much lower (54% versus 168% in Russia currently), yet MNP was unable to derail the downward secular trend in churn. As such, while near-term churn could tick higher in Russia, we expect the long-term impact to be negligible.
Tactical Improvements at MTS Should Drive ARPU and Margins Higher
Despite macroeconomic and sector-specific headwinds, we continue to see solid operational momentum in many of the key performance indicators for MTS. The average revenue per user, or ARPU, and minutes of use, or MOU, are rising on a year-over-year basis--a trend we expect to continue given the secular shift toward increasing data demand and smartphone/tablet penetration. We anticipate ARPU rising by just under 5% annually over the near term, as the growth in minutes of use (high-single-digit percentage range annually) and data proliferation offsets the slightly lower average price per minute.
While we expect churn to rise somewhat with the introduction of number portability, we don’t anticipate that it will meaningfully move the needle thanks in part to moves made by the MTS management team, including the introduction of innovative tariff plans, changes to the dealer commission structure, and a renewed overarching focus on attracting and retaining higher-value subscribers.
Specifically, MTS was the first carrier in the Russian market to offer tariff plans (dubbed Super MTS and Super Zero) with free on-net calling to boost minutes of use, with the idea that the more people talk, the more time they spend with their phone. This creates a snowball effect of customers not only using more texting and data but also acting as ambassadors for the firm as they try to recruit family and friends into the MTS network. This has been a foundation for MTS increasing loyalty and lowering churn. Since introducing the new initiatives in 2011, the firm’s churn has fallen by roughly 300 basis points. VimpelCom and MegaFon have since followed suit with similar plans, but we view this as a catch-up rather than a leapfrog, and the competitive landscape hasn't changed meaningfully as a result of these moves.
Next, MTS made structural changes to compensation plans for its independent dealers, which also lowered churn. Here, instead of paying fees up-front for connecting subscribers, MTS is now sharing revenue with the dealers. Dealers now get paid only if a customer stays in the MTS network and generates actual revenue for the company. This virtually eliminated fraud, since the dealers are no longer incentivized by blindly giving away SIM cards to inflate the number of additions, but are instead focusing on the quality and duration of the subscribers' contracts.
Based on a superior network (discussed further below), which has generated higher data contributions, MTS has increased its ARPU. Put in perspective, data now drives more than 25% of MTS’ Russian mobile revenue, nearly double the reported percentage for rival VimpelCom. This has helped MTS expand its Russian EBITDA margin this year (now roughly 45%), while VimpelCom’s has declined (42.4% through nine months). Looking ahead, we expect margins in the sector to hold steady as favorable ARPU and MOU dynamics are primed to be largely offset by increased demand-driven network investments and startup costs associated with retail network expansion initiatives. With regard to costs of goods sold, both MTS and VimpelCom recently began selling the iPhone again after pulling it from their stores in early 2013. While VimpelCom made a deal directly with Apple (AAPL), MTS is going through third-party distributors to avoid being handcuffed by a sizable up-front purchase commitment from Apple. We believe this should give the firm added financial flexibility and an edge going forward in economic efficiency.
Additionally, one reason why the iPhone has not historically sold well in the Russian market is because, unlike in other parts of the world, carriers do not pay handset subsidies. Not only do MTS, VimpelCom, and MegaFon (which collectively own more than 80% of the mobile market) have no interest in paying subsidies, but there are legal restrictions against offering them. As a clever workaround, which both drives device demand and aids the MTS revenue model, subscribers still pay full price for devices up-front, but MTS then offers customer credits that can be used for mobile Internet access on its networks, enabling the firm to generate strong customer loyalty without having to allocate an exorbitant amount of capital to devices.
Network Quality and Geographic Footprint Give MTS a Narrow Moat
Given its network infrastructure, retail footprint, and geographic footprint, MTS has a few sustainable competitive advantages that will likely translate into higher market share, lower churn, and stronger margins. Network quality at MTS is much stronger than it is at VimpelCom, a firm that underinvested in its infrastructure over the past few years and is now in catch-up mode. By comparison, MTS has nearly 35,000 3G/4G base stations throughout Russia, roughly 30% more than VimpelCom, which translates into a more robust network with much faster broadband speeds. In a recent test study completed by Ookla, MTS generated mobile download speeds (kbps) that were not only industry-best but also more than 80% faster than VimpelCom, as shown in the exhibit below. In fact, in virtually every market tested, MTS was the market leader in terms of network data speeds.
Network Speed Superiority Gives MTS a Key Edge Over VimpelCom (Third-Quarter 2013)
Source: Ookla Net Metrics
MTS also owns the largest monobrand retail footprint, with roughly 4,000 stores, almost four times as many as VimpelCom. While each firm owns 25 megahertz of 4G spectrum, MTS is in a better position to exploit it, given the firm's superior network and broader distribution.
While VimpelCom plans to increase its capital expenditures in Russia (expected to go up to 22% of revenue in 2013 compared with 18% in 2012), we estimate that the $6.4 billion the firm will probably spend in Russia through 2015 will still cumulatively be 4.3% ($150 million) less than MTS spends during that period. This is because while VimpelCom will have higher capital intensity, MTS is working off of a bigger Russia revenue base than VimpelCom is. Thus, we doubt VimpelCom will be able to close the network quality gap.
Based on Its Operational Advantages, We Believe MTS Is a More Compelling Investment
Our fair value estimate for MTS is $26 per share, and at current levels (around $20) we view the stock as fundamentally undervalued. We project revenue to increase at a 4.9% compound annual rate for the next five years. Revenue will continue to grow despite lower subscriber growth (between 3% and 4%), as usage and data services continue to drive higher revenue per customer. Margins have started to expand again thanks to the expanding ARPU and the changes in its dealer commission structure. Smartphone proliferation and data usage should drive ARPU to grow at roughly 5% for the next few years. That said, even without subsidies, the cost of goods sold will rise with smartphone growth, and thus margins will remain largely flat over the next few years. However, as revenue increases and capital intensity remains at roughly 20%, we expect free cash flow to rise steadily over the next five years.
Of the two publicly traded names in the Russian telecom space, we believe MTS holds a few key edges over its archrival VIP. One key advantage for MTS is the aforementioned network superiority. Its stronger network not only alleviates the need for heightening its capital intensity, but it could allow it to steal more customers from VimpelCom given the introduction of MNP. Another critical edge for MTS is that all of its operations are in emerging markets (Russia, Ukraine, Armenia, Turkmenistan, and Belarus), which are still generating organic subscriber growth and margin expansion. VimpelCom, on the other hand, has its operations spread across 18 countries, some of which (such as Italy and Canada) are struggling because of the economy, regulatory pressures, or competitive environment. In fact, Italy is now VimpelCom’s second-biggest market, and its revenue and earnings are both declining. That is a key reason why VimpelCom, through the first nine months of the year, has seen its revenue, EBITDA, and EBITDA margin all decline. Over that same time frame, MTS has been able to improve on all three metrics. VimpelCom is also embroiled in a messy dispute with the Algerian government for control of Djezzy, its operation in that country. The dispute has gone on for more than five years, and with no resolution in sight, the issue will remain an overhang for VimpelCom’s shares.
Lastly, MTS outshines VimpelCom in terms of ROIC, free cash flow yield, and net leverage. Because of its superior growth profile, and the comparable valuation, MTS is the more compelling investment case, in our view. Because of its operational footprint, which skews toward faster-growing markets, we project Mobile TeleSystems to increase its revenue base by a roughly 5% compound annual rate through 2017, while VimpelCom is expected to grow by only 1% during that same time frame. MTS also should produce higher returns on invested capital and generate a higher free cash flow yield than its higher-leveraged rival. In early February, MTS raised its dividend payout (to a minimum of RUB 90 billion or $2.6 billion per year) while VimpelCom slashed its own dividend by more than 50%. While the Russian stock market has had a difficult start to the new year, we believe MTS gives investors an excellent long-term opportunity for share-price appreciation.
Imari Love does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.