Telcos: the dotcom crash all over again?

One of the market themes that is starting to looking interesting is telcos. You know, those boring mature industries, whose fixed phone line legacy business is gradually being whittled away by the internet?    

The ones who are dying a slow death whilst being whipped by regulators at the same time?    

Doesn’t really sound attractive?

Well some of the charts bear this horror story out – take a look at the largest Australian telco, Telstra for example:  

If you’ve been sitting in this stock for 5 years you wouldn’t have been too pleased – and why should the situation change?   

For example isn’t it the case that:    

• telcos like say Telstra are haemorraghing fixed line subscribers and competing at the same time with VOIP?
•  cellphone service providers like Vodafone are going to be wiped out by upcoming technologies like Wimax?

Well… maybe … and maybe not.

Telco investment risk mitigation factors

What if it’s not quite as bad as the market perceptions of risk? What about:   

• PEs in single digits and high dividend yields (5-10%)
• growing broadband subscribers
• growth in mobile data (all those iPhones out there are the automobile equivalents of Hummers in the smartphone world and there is an avalanche of iPhone pretenders from manufacturers like HTC for Android – and soon Windows Phone 7 – emerging every month now)
• in the case of the larger telcos quite geographically diversified operations (i.e. natural currency hedges)
• for segments like mobile data with significant network effects (users want the widest possible signal coverage wherever they travel) there is limited competition from only one or two other players 

Here are some comparative figures for BT and Telstra (mixed mode telcos) and Cable and Wireless and Vodafone (more mobile based revenue): 

Valuation Comparisions 14/12/09	PE	Price / Cashflow	Market Cap £ Billion	Rev Growth 1Y % *	Div Yield 13/6/10
BT	7.48	2.5	9.7	-2% *	5.44
Telstra	8.97	4.05	20	-2.9% **	8.8
Cable & Wireless Communications	11.92	6.52	1.5	n/a	9.8
Vodafone	8.41	5.81	70	-1.6% *	6.44

* Preliminary results to 31/3 

** half year ended 31 Dec 2009 v same period previous year 

The low digit PEs imply there is relative risk about some of these companies (and yep, as we all know it’s really risk that revs up your return).      

On the risk to fixed line revenues as they migrate to mobile-only households point consider a situation where 25% of the population works from home all of the time and a good proportion occasionally.  Are they going to rely solely on wireless for their connection to the cloud and business contacts?

What about the booming online gaming market (where latency is really important)? And what about the increasing availability of online movie download systems (whether legal or illegal!) – with the average movie over a gigabyte in size (Cisco is currently forecasting huge growth in video traffic over the next few years)?  

And as for the VOIP point, again you still need the underlying wireline for VOIP. And for many of these (use of web based applications, increased video, and voice)  latency is important and data flowing back ‘up’ the pipe to the telco is important (as opposed to situations like cable television based internet connections where the ‘up channel’ is much slower).   This all means more data coming up and down the pipes owned by these telcos.   

Wimax reportedly has quite a lot of issues in handling high volumes of traffic at its backend, and just to further naunce (hopefully that’s a verb) this picture there is also the issue of IPv6 (the world basically running out of IP addresses so if you currently have significant IP address range allocations, as some of these companies do, that could be regarded as a valuable asset).   

The best telcos if you believe data demand will support these stocks

If you think that perhaps reports of the death of the fixed line has been greatly exaggerated and data demand will soar, where might you go?  

Vodafone

Well Vodafone is more of a pure-play in mobile data if you look at their revenue  breakdown:

Vodafone
voice	66%
messaging	12%
data	11%
fixed line	8%
other	4%

 

but at the same time it is a very European play if you are worried about currency exposure with about 3/4ths of its revenue from Europe.  

     

So Vodafone’s one possibility if you are not worried about the Euro exposure. 

BT I have also been in and out of over the last 18 months however the issue with BT as a pure play (on the rise in IP-based data consumption on mobile and fixed lines) is that it has a large services component.  

If, however, you do not think it’s necessary to discriminate between telecoms companies on the basis of the revenue splits and currency exposure you could also always consider iShare’s Telecommunications ETF. Top holdings as at  11 June 2010 might also give you some other ideas as to specific stocks:

15.59%	AT&T INC
11.21%	VODAFONE GROUP PLC
8.42%	VERIZON COMMUNICATIONS INC
8.06%	TELEFONICA SA
5.14%	CHINA MOBILE LTD
3.88%	FRANCE TELECOM SA
3.50%	DEUTSCHE TELEKOM AG-REG
3.14%	TELSTRA CORP LTD
3.12%	NIPPON TELEGRAPH & TELEPHONE
2.70%	AMERICA MOVIL-ADR SERIES L

Cable and Wireless Communications

A less obvious play on mobile data (and less popular than Vodafone) which I’m currently holding is Cable and Wireless Communications

CWC
mobile	40%
broadband	9%
domestic voice	19%
international voice	8%
enterprise, data and other	24%

 

which is 84% USD “pegged or earned” revenue but diversified across some more interesting geographical regions (which however are not Europe and not the USA) such as Panama, the Caribbean, Monaco, and Macau (in order of descending EBITDA). 

The chart is somewhat meaningless since it was demerged from C&W earlier this year but here it is if you want to look at it. 

Telstra

Finally, I also hold Telstra (see chart at the top of this article). 

It is currently plagued in somewhat similar manner to BP by issues around regulatory risk as the Australian government implements the national broadband network.  

However it is also a very widely held share in Australia (i.e. the government would lose a lot of votes if it destroyed the value in it) and BT survived being split into a wholesale and retail arm so I think it is likely that Telstra will also survive.

The risk of the publically funded National Broadband Network (NBN) fibre to the home project not buying its assets or doing a deal with it is really factored into the price at this point – and looking at its revenue sources is probably most likely to impact on an area that is already in decline (PSTN revenue):

Telstra
mobile	36%
pstn	34%
fixed retail broadband	9%
ip and data access	10%
ads and directories	11%

 

Telstra saw a reasonably chunky fall in PSTN by 6.9% over the last half year but actually would have actually had a revenue increase in spite of this if not for a fall in advertising revenues, and actually grew free cashflow by 37% to the end of 2009 (you almost have to feel sorry for Telstra management in the circumstances). 

Telstra seems like a stock where the bad news is in the price: it’s mostly A$ exposure (and with franking if you are an Australian shareholder the dividend is huge) and my view is that it makes sense just to wait out the regulatory / NBN uncertainty and be paid while you do.

You would not be entirely alone if you decided to hold it:  Maple Brown Abbott, a good long term value fund here in Australia, has Telstra as their largest holding.

To spread your risk further you could probably safely hold all three: Vodafone, CWC, and Telstra.

Posted under individual stocks, Risk

Video games: still a long term growth story

For a few years now the video/computer games sector has looked attractive as an investor. 

As most people would now be aware video games have passed movies in terms of gross revenue and there are a bunch of  factors which make them extremely interesting as a long term growth story.

For example:

1. increased availability of high speed broadband
2. increased availability of large, high definition screens in the home
3. the growth of whole new genres which are different from the traditional shoot-em-ups such as edutainment titles which teach children far more effectively than any human teacher could, and gaming physical fitness titles exemplified by the Nintendo’s Wii Fit series which have redefined the user interface so that physical activity forms a strong component of the game
4. social gaming systems such as World of Warcraft (owned by Activision) with 11m players
5. new generations for whom gaming is not a marginal activity such as the under 20s and increasing numbers of women gamers

At the same time as a sector it’s pretty damn scary. 3-5 year console cycles cause stock prices to fluctuate like a yo-yo and it perhaps bears a passing resemblance with large title production costs and big marketing budgets to the movie business (not a business that looks tempting as organisations like Vivendi and Sony have learned to their cost). Equally there is the argument that, like the music business, titles can be pirated with high speed connections. Looking at all this you just have to keep reminding yourself equity investors really get returns for taking on risk…

However something that has significantly changed is that the multiples on all these gaming stocks have fallen over the last couple of years which is what makes them more interesting at the moment from the perspective of a value investor in what used to be regarded entirely as a growth stock play.

The big cap pure-play video games companies

The three big (pure) players are Activision, Electronic Arts, and Nintendo (given the risk levels on individual titles the smaller companies seem to be significantly riskier). None of these companies have any debt and all have significant cash on the balance sheet (in Nintendo’s case net assets excluding intangibles accounts for over a third of its market cap – about US$8bn of which is cash).

Whilst Sony and Microsoft are of course large in the games industry as well they also have other priorities and it looks hard on the surface of it to disentangle their games activities and the resulting impact on their stock prices from their other businesses.

Long term (see chart here) Activision seems to have tracked Nintendo (both of which are generally thought to have excellent management teams) up until the beginning of 2009, whilst comparatively Electronic Arts has languished in the last 2 years (EA focusing heavily on sports titles compared to the other two).

Comparative valuations for Activision, Nintendo and Electronic Arts

Some comparative valuation metrics for all three stocks are listed below:

 

Valuation Comparisions 14/12/09	Forward PE	Price / Cashflow	Price / Cashflow 3 yr avg	Market Cap USD Billion	Rev Growth 1Y %
Activision	14.06	21.55	54.43	13.6	124
Electronic Arts	13.61	62.11	53.86	5.2	15
Nintendo	12.09	13.33	54.28	34	10

 

There is some degree of fear out there on these stocks – see “Can Nintendo Rebuild?” for example in Businessweek. Generally video game sales have not been good recently (Nintendos’ sales fell for about 8 months straight this year and it expects annual revenues to fall for the first time in 6 years), there is nervousness about the impact of social gaming via systems like Facebook, and the rise and rise of iPhone games has made people wonder what impact that might have on dedicated handheld devices like the Nintendo DS or Sony PSP.

Nintendo, for example is trading at half its price in 2007:

 
 and even Activision with the recent success of its Call of Duty: Modern Warfare title is trading at $10 or so from a high of $18 back in 2007 (but not an apples for apples comparison given its 2008 merger with Blizzard and their World of Warcraft franchise). 

Of these 3 stocks it is Nintendo that seems to jump out (although both Activision and Electronics Arts are trading below Morningstar’s fair value estimate and it would probably be entirely reasonable to take a diversified bet on all 3).

The case for investing in Nintendo?

As a US$34bn company with the majority market share in many areas (Sony has sold about 9m PS3 units in the UK with Nintendo selling 25m Wiis)  Nintendo is surprisingly hard to find investor coverage on – Morningstar in the USA for example does not provide analysis on it.

If the reason is concerns about the way that some Japanese companies are run, these don’t seem warranted in Nintendo’s case.  At current stock prices they even pay a 5% dividend – the only company of these three to do so and a rarity in the games industry generally.

Nintendo is however definitely a long term bet. Their revenue has halved in the last 6 months compared to a year ago and a chartist probably wouldn’t touch them with a bargepole.

However they are still busily shipping units of the Wii (with a price cut) and the portable DS (with roughly 10% of the all time entire total sold in the last 6 months) and if you look at their geographical revenue split what happens in the US is both very important but equally very impacted by US dollar weakness (the USD having fallen against the Yen by about 20% over the last 2 years).

 

Nintendo by region
6 months to Sept 30th 2009 (million yen)
Japan	92071	17%
Americas	228938	42%
Europe	186630	34%
Other	40418	7%
Nintendo by activity type
6 months to Sept 30th 2009 (million yen)
Hardware	312556	57%
Software	234187	43%

 

As the activity type table above suggest Nintendo is not just a hardware company with revenue over this period (during which not many new titles were released) being split about half software, half hardware. Recent falls in revenue reflect a lack of new compelling titles or hardware launches but the company’s franchise with casual gamers places less stress on coming up with radical new cutting edge consoles (as is the case perhaps with the Xbox or Playstation). Their Mario Brothers franchise is still going strong and the title was released in 1983!

The concerns about the iPhone seem to be overrated to me. The iPhone lacks gaming controls so you have to use your fingers on the screen (reducing its visual area), it comes with data charges, and to argue that gaming apps are cheaper for the iPhone is a little like arguing  that nobody is going to go to the cinema because they can watch movies for free on television (the better movie experience still counts for the consumer).  Just on that minor point $10 for  cinema ticket for a one-off 2 hour’s enjoyment still seems to be outranked by potentially weeks of enjoyment in sharing a game with your family at home.

Neither, if you look at Nintendo’s R&D spend, does it look like Nintendo intends to stand still with a high definition Wii supposedly in the works as well as link-ups with organisations like Netflix. Yes, motion-sensing controllers may well be on the way from Sony and Microsoft but this is a company with a history of innovation.

Nintendo’s management has successfully broken into whole new areas – with a market share for example of up to 80% of US female gamers and almost singlehandedly created a new genre, the fitness/exercise game.

Nintendo’s profitability and track record makes their US ADRs look like a buy (US: NTDOY) and the rumours of a stock split would make them more attractive as well. However looking at their chart averaging in looks warranted – this is not for the faint-hearted.

More information on Activision at http://investor.activision.com/reports.cfm

More information on Nintendo at http://www.nintendo.co.jp/ir/en/

Posted under individual stocks

The current wholesale sell-off in global stock markets is leading to many a baby being thrown out with the bathwater! Inevitably there are some stocks which are being sold off which are sound businesses.  There are certainly far more exciting investment opportunities out there than there have been at for a good four years.  No doubt the forthcoming economic recession will have an impact on all industries, and most companies will see a significant reduction in revenue, profits and cash flow. Many however are currently being priced as if they will go bankrupt, or head into a long painful terminal decline. Some of these very undervalued companies might even manage to grow earnings in the forthcoming recession. 

Cable & Wireless: business segments and spin-off discussions

One example is Cable & Wireless in the UK.  Cable & Wireless essentially has two distinct businesses. The growing internet and broadband division for corporate customers in Europe, Asia and the US, and the International division which includes the legacy cash generative telecoms businesses in the Caribbean, Panama, Macau and Monaco.  For years shareholders have argued that the combination of these two divisions is not strategically compelling and that a demerger would be the best way to realise value.

Earlier this year management announced that they were considering strategic options including a demerger and returning cash to shareholders.  In the following months, the share price rose 20%, dramatically outperforming the sector, but in the last few weeks it has fallen over 30%.  Part of the reason for the recent stock price sell off is that management have suggested, quite sensibly in my view, that the current market turmoil is hardly the time to be realising value via a demerger and spin-off.  This does not signify a change in strategic thinking but rather a delay until more rational markets prevail.  

Cable & Wireless’s acquisition of Thus

C&W has also recently completed a takeover of its smaller UK rival, Thus.  Even after paying £361 million for Thus, the company will still be significantly underleveraged with a net debt position of £184 million, less than 10% of equity. The purchase of Thus, following on from the acquisition of Energis in 2005 gives C&W increased market share and helps them consolidate their position as a clear number two to BT in the provision of internet services to corporate customers in the UK.

Cable & Wireless: guidance and valuation

In the June 2008 interim statement, management said it was on track to achieve its guidance of a 20% increase in operating profits for this year. Let’s be conservative and assume that current economic circumstances mean C&W will not achieve any improvement in the underlying going concern this year or next. At the current price, this would put the business at a very reasonable 6.6X cash flow.  The dividend should be secure too; giving a current yield of 6%. Throw in likely cost savings from the Thus acquisition, and a potential special dividend from the eventual separation of the two key businesses, and it seems to me that Cable & Wireless is a bargain.

Disclaimer:  Note the author may hold investments in any of the companies mentioned in this article. Any new investment should only be considered in the context of the risks in your existing portfolio.

Posted under individual stocks

In the light of the 10% fall on Nasdaq yesterday we have been wondering today what might be out there in the way of opportunities (from memory the Nasdaq has now fallen roughly 50% from its peak).

There was a wholesale sell-off in the tech sector and we wondered whether everything should be tarred with the same brush. Just how similar say, are Dell and Ebay and Google in reality?

If you were looking to do some bottom-fishing for an opportunity then perhaps some worthwhile characteristics would be:

• a stock that was pretty well disliked
• a stock that had a nice balance sheet
• a stock that was well diversified across multiple markets and geographical sectors
• a stock without a sky-high valuation
• a stock where some of the analysis looks uninformed

People hate Ebay

Unlike internet darlings such as Google or Salesforce.com, Ebay’s halo is regarded as slipped by a lot of people, including Peter Lynch style investors who think because they use a product and it works it’s worth buying. Have a look at a 5 year chart and you’ll see it was trading at $58 3 years ago, as compared to 20 bucks today.  Analysts are pretty well split and there is ton of negative publicity out there from pissed-off sellers which you can find appended as comments to any discussion of the stock objecting to everything from changes to feedback ratings to Ebay’s attempts to ‘encourage’ their buyers and sellers to use PayPal.

Ebay’s balance sheet

Doesn’t look too bad. At a guess I would say there are going to be a lot of opportunities out there if you’re pulling in free cash flow of $2.1bn (2007) and you’ve got $3.4 bn sitting round to pick up other nice businesses which are not in such a good position because they’re busily building market share and not worrying about cash or profits and investors don’t seem to like that at the moment. And after probably seriously overpaying (from memory $2.1bn) for Skype they are hopefully not going to make that mistake again too quickly (management change might also suggest that with the departure of Meg Whitman).

Ebay is diversified

With basically 3 businesses: payments in PayPal, the much smaller communications business with Skype, and the merchant side auction business, Ebay has a few different bets. From memory about 40% of their income comes from outside the USA too.

Ebay’s valuation

Float over to Morningstar and you find Ebay’s fair value estimate at about $40. They say consider buying at $30. You can find some competitor analysis here but their price/sales, price/cashflow and PEG don’t look bad compared to some of their peers like Amazon, Google, and Yahoo.

Ebay angles off the analyst radar screen?

There may be a few bright spots that are being underestimated:

1. PayPal is growing fast. In Ebay’s Q1 2008 (April) financial results [Morningstar analyst quote] “total payment volume from the Paypal online payment service increased 17% on the eBay platform and a remarkable 61% off the platform” . By ‘off the platform’ they mean people using Paypal accounts to pay for other stuff via other websites. Whilst there are other competitors it looks to me like Ebay is leveraging their auction position (under the guise of ‘safety in transactions’) to push Paypal where some of their competitors like Google can’t – another situation where Ebay could establish a pretty dominant franchise.
2. When money gets tight where do consumers go to buy the cheapest products? Pawnbrokers seem to have been valued on the basis that they might benefit from a switch downmarket as with cheap supermarket chains like Aldi. Why not Ebay?
3. Skype seems to be working better and better – there are lots of VOIP plays out there but call quality to normal phones seems to be good and there’s not a lot of other options when it comes to the utility of knowing people are there waiting to take your call and quick and easy ad hoc conferencing. For small businesses you could argue that Skype is becoming essential.

Other analysis of Ebay

Moneyweek: http://www.moneyweek.com/investments/tip-of-the-week-time-to-buy-this-chip-makers-plummeting-shares-13797.aspx

Motley Fool: http://www.fool.com/investing/value/2008/10/09/this-just-in-upgrades-and-downgrades.aspx

Posted under individual stocks