Hang Up on Cellcom Israel

Cellcom Israel (NYSE: CEL), the leading cellular operator in Israel, on March 2nd reported record full-year financial results for the third consecutive year. Operating income, free cash flow, and earnings were the highest in the company’s history. The stock has been on a tear over the past year and since its February 2007 IPO, up 99% and 156% on a total return basis, respectively, compared to returns by the S&P 500 ETF (NYSE: SPY) of only 72% and –16%.  

Leader in its Field

A significant cause of Cellcom’s success has been Israel’s triopoly mobile-phone market structure:

Source: Form 20-F (filed March 2, 2010)

With only three major players in the market, price competition has been restrained.

A Strong Economy Helps

Furthermore, the Israeli economy has been an oasis of prosperity during the 2008/2009 global financial meltdown. According to Fitch ratings, Israel is one of only four “A-rated” countries to escape a recession in 2009 (yes, China is one of the other three). In affirming Israel’s “A” credit rating back in November, Fitch stated:

Israel has fared better than many other small, open economies in the global economic and financial downturn. This performance is attributed largely to a relatively trouble-free banking sector and an absence of asset price bubbles. Structurally, Israel’s high-tech manufacturing and services sectors have proved unexpectedly resilient to declining global investment demand, presaging a record current account surplus in 2009.

High Rankings for a Small Country

And it doesn’t hurt that Israelis love to talk and are technologically savvy.  In the 2009-2010 Global Competitiveness Report by the World Economic Forum, Israel ranks 19th in the world (out of 133 countries) in mobile phone penetration with 127.5 phones per 100 inhabitants and ranks 9^th in innovation. High-tech value-added services (VAS) such as mobile Internet, ring tones, text messaging, and video games are much higher margin than plain old voice service and VAS revenue allows Israeli cellular operators to grow their profits despite the country’s 100%-plus penetration rate.  

Increasing Competition On the Horizon

So Cellcom is a screaming buy, right? Wrong.  Israel’s cozy triopoly cell-phone market is changing and fast.  A “number portability” requirement was enacted in December 2007 allowing subscribers to switch carriers without having to forfeit their original phone number. Technological snafus, however, have prevented portability from meaningfully going into effect until recently. In fact, Cellcom and the other carriers face legal liability for failing to meet the December 2007 deadline. 

But an even more important competitive threat looms: mobile virtual network operators (MVNOs).  Moshe Kahlon, the government’s new Communications Minister, recently called Cellcom, Partner, and Pelephone a “controlling group” that has stifled cellular competition. Consequently, this past December, the Ministry started to break the competitive logjam by encouraging new entrants through the issuing of MVNO licenses. MVNOs are cellular resellers who will be able to buy capacity from the facilities-based carriers at a wholesale discount and resell the service to retail consumers. According to Kahlon, MVNOs could take a 7% market share, or 630,000 customers, away from the incumbents.  Kahlon is also planning to get another facilities-based carrier licensed.

In Cellcom’s latest earnings conference call, CEO Amos Shapira admitted that increased competition hurt mobile-phone pricing in 2009, noting that the average monthly revenue per subscriber decreased by more than 3% despite the fact that average monthly minutes of use actually increased. With regard to MVNOs, Shapira insists there will be no strategic threat to Cellcom’s business, but concedes there will be “short-term damage.” 

Lastly, Apple’s (Nasdaq: AAPL) iPhone has invaded Israel and its large existing base of value-added services threatens to deprive domestic mobile-phone carriers like Cellcom of a substantial portion of the high-margin VAS business they have relied upon for growth.

Don’t Be Fooled By Current Earnings

Cellcom doesn’t look that expensive at only 11 times trailing earnings and yielding more than 7%, but the record earnings of 2009 may turn out to be peak earnings.  Indeed, the consensus analyst estimate for 2010 earnings is a decline from 2009 levels.

And keep in mind that foreign company dividends – as opposed to U.S. dividends – are not fixed but float as a percentage of earnings. Cellcom currently pays out 95% of its income in dividends, so if its earnings go down, so will its dividend. Furthermore, a 95% payout ratio appears excessive for a capital-intensive business that needs to reinvest in network maintenance and technological upgrades. 

In fact, the company appears to be incurring debt in order to make the necessary capital expenditures. Long-term debt is quite steep at $1.1 billion compared to shareholder equity of only $99 million. 

Growing Market, But Weaker Future Profits

The Israeli mobile-phone market is healthy and continual innovation promises strong growth ahead. But a strong-growth market does not automatically translate into strong profits for individual companies.  Increased competition will mean decreased profit margins for incumbent mobile-phone operators like Cellcom and I’m betting that their share prices will follow suit and decline as well. Given the deteriorating profit prospects for cellular service companies, it’s not a surprise that Utility Forecaster editor Roger Conrad rates Cellcom competitor Partner Communications a “sell.” I believe that Roger’s investment conclusion regarding Partner Communications is right on the mark and applies to Cellcom as well.

Bottom line: It’s time to ring up your profits and hang up on Cellcom.

===============================================================

Interested in foreign telecom investments? Roger Conrad may not be bullish on the Israeli cellular market, but his Utility Forecaster newsletter service has issued strong buy recommendations on a select group of seven foreign telecom stocks right now. Yiannis Mostrous’ Silk Road Investor also has four foreign telecom stocks in its long-term emerging markets portfolio. Try both Utility Forecaster and Silk Road Investor risk-free to find out which foreign telecoms made the cut. There is no obligation to subscribe.