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Tattelecom – Russian Value Trap with 80% upside

Date: 23 Mar 2013

Tattelecom (JCS Tattelecom, TTLK): fixed line telecom operator in Russia. Fundamentals are appealing:

Regional leader with > 50% market share
EV/EBITDA 2012E=2.1x
Stable dividend yield: 6.6% for 2012, 2.5%-18.7% for 2006-2011
80% upside based on DCF
130-180% upside based on comparables

What is this: strong BUY, ideal LBO candidate or a value trap? Let’s take a look at its fundamental value and how it could be realized.

1. Revenue forecast – below inflation growth from fixed line telephony and broadband internet

Tattelecom is a fixed line telecom provider in Tatarstan – one of Russia’s regions with 3.8m population and 75.9% urban citizens.

Tattelecom on 27 Apr 2012 expanded to mobile market: it became an MVNO using infrastructure of Smarts – mobile operator from Samara. As Tattelecom is just at the beginning of its way to mobile, it’s difficult to estimate mobile influence on revenue, margin and CAPEX. In this analysis

- it’s assumed that the mobile segment will generate average return on capital
- mobile revenue and related CAPEX are not modeled

1.1 Fixed line telephony market – slow ARPU growth with slow subscribers decline

Tattelecom was formed as a fixed line telephony operator and continues in this way: 54% of 2011 revenue came from fixed line telephony. Fixed line telephony is a declining market by number of subscribers. How fast will the decline happen and will it be compensated by ARPU growth?

To analyze that I looked at fixed line telephony data for the biggest telecom operators WW. They usually have dominating market shares in their respective countries and thus changes in their revenue, subscribers and ARPU approximate market behavior.

Fixed line telephony subscribers, APRU and revenue change for top operators WW

Source: Capital IQ

Note: the difference between the speeds of subscriber decline for Business and Residential segments are not very different for benchmarks: 1-2%, so the difference in the mix doesn’t cause material differences between companies.

The best and the only Russian benchmark for regional fixed line telecom services is Rostelecom. Its data shows accelerating decline speeds in number of subscribers.

Rostelecom fixed line telephony: subscribers and ARPU growth

Source: Rostelecom

Rostelecom – fast ARPU growth with fast subscribers decline strategy:

High APRU growth policy lead to sharp acceleration in decline speeds which reached 4.5%.
As a result Rostelecom made a correction in ARPU growth and decreased it to 3.6% as of Q3 2012
This strategy is close to BT in the last 3 years and Telecom Austria in the last 5 years

Tattelecom historically followed “slow ARPU growth with slow subscribers decline” strategy which is close to global benchmarks. I assume Tattelecom will continue using it going forward. More specifically:

Subscribers

Fixed line market declined 6% in 2009, 1.5% in 2010, 1.7% in 2011 (based on indirect data). Global benchmarks assume 6% decline
I would assume based on historical data that the market will not deteriorate so quickly and will achieve 5% CAGR decline speed in 2017

APRU

Global benchmarks assume 1% growth
In 2011 and 2012 Tattelecom showed 4.2% and 2.2% growth
I would assume 2% for 2012 and 2013 and then 1%

1.2 Fixed broadband internet market – Tatarstan is ~4.5 years behind developed European countries

Broadband internet is rapidly developing in Tatarstan – penetration is only 51%. The question is when this growth will stop.

Fixed broadband penetration in Tatarstan - estimation

To analyse this I looked at the history of key European markets.

Source: World Bank, Eurostat

Based on the above data, I assume that Tatarstan is 4.5 years behind developed European markets and forecast subscriber growth as an average for two relevant years from the benchmark. For example, 2012 growth rate is an average for 2007 and 2008 growth rates.

Fixed Broadband penetration in Tatarstan - forecast

The real rate may be slower: mobile broadband and Smartphone penetrations are higher now than they were in Europe 4.5 years ago which provides considerable competition for fixed broadband.

Additional data point can be found for other regions for residential broadband internet (source: AC&C):
- Russian market grew 15% in Q3 2012 vs. Q3 2011
- Moscow (a saturated one with good organic growth prospects) grew 4% in Q3 2012 vs. Q3 2011

Russia residential broadband subscribers growth

Source: AC&C

Tattelecom fixed broadband ARPU forecasted as a slow 2% decline in 2012-2014 and stabilization to 0% since 2016 as it happened in Moscow.

1.3 Revenue forecast – from 3.7% growth in 2012 to 0.1% in 2017

For both segments I assume based on historical data that Tattelecom’s market share will remain constant.

Tattelecom revenue forecast

2. EBITDA Margin – stable, no reasons to believe in improvements

Tattelecom EBITDA margin (37.6% in 2011) is above average among WW fixed line telecom providers, but is almost the lowest among cable operators in Europe and US. I believe there is a clear potential to grow EBITDA margin:

- Ziggo while run by PE owners achieved 56%
- Rostelecom showed 38.4% in 2010, 39.5% in 2011

At the same time, there are no signs from Tattelecom management that they have abilities, desire and plans to do that.

Tattelecom EBITDA margin is forecasted at the same level as in 2011: 37.6%

Source: Capital IQ

EBITDA Margin of top worldwide cable operators

Source: HSBS, Ziggo, 1 May 2012

3. CAPEX – assumed at 20-22% of revenue

Average CAPEX as % of Revenue was at 23% for 2008-2012 while average data for WW comparable companies suggests 16%. 2012 showed 22% based on RAS accounting.

High CAPEX were probably attributed to the historical fast growth in broadband internet which required a lot of upfront investments. As it was assumed before, active growth in broadband penetration will continue for 2013 and 2014. I forecast CAPEX/Revenue at 22% for 2013 and 2014 (in line with 22% in 2012) and then 20%.

4. DCF Valuation: 80% upside

DCF valuation is done for 01.01.2013.

Tattelecom DCF valuation

Tattelecom DCF valuation sensitivity

Potential upsides for DCF:
+ Slower decline of fixed line telecom subscribers
+ Broadband internet growth faster than expected
- Deterioration in EBITDA margin due to wages inflation and not enough optimization

5. Russian and Global comparables: 130-180% upside

The most relevant comps for Tattelecom are Russian telecom companies as Russian stock market overall has a big “country risk” discount.

By any of the 3 multiples Tattelecom has 130% growth potential, or more than two times cheaper.

For comparison below is a list of global benchmarks (except one outlier with 56x). The median is 5.9x which means that Tattelecom has 180% growth potential.

6. Value realization scenarios: probability is unclear

How could this huge value upside be realized? Realistically, only through change of control in the following scenarios:

Acquisition of Rostelecom
LBO
Privatization on an open auction

But, how is it viable? Owner of Tattelecom Svyazinvestneftehim sold nothing to external companies since 2005. Their strategy is “hold forever” so they probably would not sell in the future and would not care about delivering value for minority shareholders. This raises a question: why is Tattelecom public at all?

7. Conclusion: it’s a convertible bond

In a nutshell we have:

+ DCF upside is 80%. Comps assume 130-180%
? Unclear prospects for value realization

This makes this stock look like a convertible bond: there are no reasons for value decline and there is a small probability for big upside in case of change of control event.

Tags: BRIC, Russia, Stocks - fundamental analysis