TeliaSonera: Bad News is Good News

Company: Telia Company AB (TELIA)

Written: Feb 2017

Authors position: Currently looking for an entry price


Overview of Investment Thesis

  • Everything that could go wrong has gone wrong for TELIA, which are now frowned upon thanks to the bribery scandal.
  • The stars have aligned for the value investor. A steady stream of bad publicity wrt. a more or less temporary setback, mixed with a general hatred for the telecommunications sector has fabricated a significant discount to fair value in TELIA.
  • The consecutive stream of bad news will contribute to higher returns in the long run. When TELIA’s stock prices fall, dividend yield rises as long as the company doesn’t cut their dividend at a greater pace than the price drop. When those dividends are reinvested, they purchases more and more shares at lower prices. Then, when the share price of TELIA reverse, the extra shares act as a return accelerator and rocket total returns higher.
  • I expect that a credit downgrade will be evident after the SEK 12 billion settlement, which will present a good entrance opportunity.
  • I advice the long term investors to initiate a position below SEK 30, putting the stocks into a tax-sheltered account (ISK), reinvesting the dividends and holding the stock “forever”.

Bad news is good news

  • SEK 10,000 placed in the S&P 500 index on February 28, 1957, would have grown, with dividends reinvested, to almost SEK 1,250,000 by December 31, 2003.
  • SEK 10,000 placed in the top-performing company from the original S&P 500 firms would have grown to almost SEK 46,000,000.

What was this golden company that beat the market by 900 bp per year over the last half century and left every other firm far behind in the race to be number one? It was Philip Morris, which in 2003 changed its name to Altria Group, Inc. (MO:NYSE).

Some readers may be surprised that MO is a top performer in the face of the onslaught of governmental restrictions and legal actions that have cost the firm tens of billions of dollars and threaten the cigarette manufacturer with bankruptcy. But in the capital markets, bad news for the firm often is transformed into good news for investors. Many investors shunned the stock in and feared that its legal liability for producing a dangerous product – cigarettes – would eventually crush the firm. This aversion to the firm pushed down the price of MO shares and raised the return to investors who stuck with the stock. As long as the firm survives and continues to be very profitable, paying out a good fraction of its earnings in the form of dividends, investors will continue to do extraordinarily well. With the price of its stock so low and its profits so high, MO’s dividend yield was one of the highest in the market. Those reinvested dividends turned its stock into a pile of gold for investors who have stayed with the company. The power of MO high dividend to propel its higher returns illustrate an extremely important principle of investing. What counts is not just the growth rate of earnings, but the growth of earnings relative to the market’s expectations. The low expectations combined with high growth and high dividend yield provided the perfect environment for superb investor return.

The rise and fall of telecoms

The telecommunication sector has a memorable history, which has imprinted a deep-seated negative sentiment in investors minds. As internet mania mounted in the 1990s, there was near-universal agreement: the Internet was the wave of the future, and profits were guaranteed for those who could provide the pipeline for this communications revolution. Growth in demand for bandwidth – the pipelan that connects users to Web sites – seemed insatiable. Many predicted there could never be enough capacity. In April 1998, Salomon Smith Barney analyst Jack Grubman prepared a research report saying, “Like the attic of a house gets filled, no matter how much bandwidth is available, it will get used.” Technology guru George Glider echoed these sentiments. In 2001 he wrote, “Today, there is no economy but the global economy, no Internet but the global Internet, and no network but the global network.” Gilder predicted that two telecom companies, Global Crossing and 360networks, “will battle for worldwide supremacy, but in a trillion-dollar market, there will be no loser.”

At first, bandwidth enthusiast were dead on. Supply struggled to keep up with demand. Prior to 1995, telecom carriers were restricted to piping only one beam of data-carrying light through the fiber-optic lines, which was the equivalent of 25,000 one-page emails per second. But a new technology, called dense-wave division multiplexing, or DWDM, essentially split the light beam into many colors, thereby multiplying the available wavelengths and capacity by up to 320. In 2002, one could send 25 million e-mails over the same strand of fiber, a thousand fold increase of capacity in just seven years. This increase far exceeded the expected pace.

Compounding these technological breakthroughs was on of the largest building sprees in history. The Wall Street Journal estimates that 40 million miles of fiber were laid during the technology bubble, enough to make more than eighty round-trips to the moon. Unfortunately for all the telecoms, demand did not keep pace with the gargantuan increase in supply. From 1999 through 2001, demand “only” quadruped, far less than had been predicted. As the glut of capacity became apparent, the telecom fims had no choice but to discount their prices. In March 2000, at the height of telecom optimism, the aggregate market value of the telecommunications sector in the United States was about USD 1.8 trillion, representing 15 percent of all stock market value. By 2002, this sector had fallen 80 percent to about USD 400 billion. The rise and fall of telecoms may indeed qualify as the largest bubble in history.

The telecommunications industry sadly illustrates how rapid productivity growth can be devastating to both firms and investors. The telecommunications industry also illustrated the point that the long-term return of a stock depends not on the actual growth of its earnings, but on the difference between its actual earnings growth and the growth that investors expected.

Obvious prospects for physical growth in business do not translate into obvious profits for investors.” – Benjamin Graham, The Intelligent Investor, 1973

The Wall Street Bandwagon

The telecom sector is certainly not what it was a couple of decades ago. The days of near-monopolistic control of landlines are long gone. These days the sector is driven by fierce competition, with new ways of communicating continually entering the market, and consistent and expensive upgrade cycles.

To Wall Street, this reduces the traditional defensive appeal of the telecom sector. As telecom businesses compete for increasingly budget-conscious consumers, pricing power have declined. In addition, companies in the wireless space are shifting their pricing structure away from long-term contracts and free equipment toward more flexible terms—potentially beneficial and more transparent for consumers, but likely squeezing profits in the sector to an even greater degree.

The expectation of rising interest rates is additionally bearish for the telecom sector. Rising interest rates will hurt the telecom sector, whose relatively high dividends often attract investors in a low-interest-rate environment. The high debt load, which is needed to support the necessary infrastructure, will cause rising interest-rate to eat into the dividend similar to a slow growing cancer.

The main negative factors Wall Street see for the telecommunications sector is.

  • Net profit margins are declining for the telecom sector as competition squeezes margins.
  • Heavy Capital Expenditure is needed to maintain international growth.
  • The telecom sector has the highest debt-to-equity ratio of any nonfinancial sector.

The contrarian position

Most of Wall-Street assessments wrt. the telecom sector is legitimate. What the Street fail to grasp, however, is the basic principle that sector growth does not decide shareholder returns, it’s value that does. Subsequently, the Street is doing completely the opposite of what’s beneficial; longing into to the bubble, and selling in the depression. Warren Buffet was wise enough to avoid the telecommunications industry while the sector was experiencing its glory growth days.

Between 1995 and 2000, growth in IT investment in real terms averaged nearly 24 percent per year, five times greater than investment in other types of equipment. 

Instead, he waited until the telecommunications sector had matured and fallen out of favour. As he understands the critical point

  • Mature business ofter tend to over-perform in the long run in contrast to fast growing and industry leading businesses, as disruptive changes often wreak havoc for shareholders.
  • What counts is not just the growth rate of earnings, but the growth of earnings relative to the market’s expectations.
  • Capital markets are very counter intuitive, bad news for the firm often is transformed into good news for investors.

The Streets bias against the telecom-sector has produced bargains to be explored. Following, I will present my premise, why I believe TeliaSonera (OMXS30:TELIA) represent a potential long candidate.

Company Discription

TELIA is the dominant telephone company and mobile network operator in Sweden and Finland. TELIA is the result of a 2002 merger between the Swedish and Finnish telecommunications companies, Telia and Sonera. This merger followed shortly after TELIA’s failed merger with Norwegian telecommunications company Telenor, now its chief competitor in the Nordic countries. The company has operations in other countries in Northern and Eastern Europe, and in Central Asia and South Asia.

Before the privatisation, Telia Company was a state telephone monopoly. Sonera on the other hand had a monopoly only on trunk network calls, while most (c. 75%) of local telecommunication was provided by telephone cooperatives. With the Finnish government selling down its stake in TeliaSonera, the company has changed its name to Telia Company.

During the run up to the 2006 general election the Swedish liberal-conservative Alliance stated as one of its policy aims to reduce government ownership in commercial entities, and specifically to sell its stake in TELIA. The Alliance went on to win the election and formed a coalition government. The sale of TELIA was, however presented to the parliament only after the next election in 2010, when the Alliance lost its majority but stayed on as a minority administration. On 16 March 2011 the Alliance administration lost a parliamentary vote on sale of publicly owned commercial entities, including TELIA, when a coalition of all opposition parties – the Left Party, Social Democratic Party, Green Party and Sweden Democrats – united against the Alliance.

Bribe Scandal

In late 2004, Skytel, a joint venture between NCI International, a US company, and state-owned Uzbektelecom, was reportedly directly approached by Karimova (the president’s daughter) with a demand for a 50 percent stake in the company. Shortly after NCI ignored the request, it found that Skytel’s frequency was jammed by an Uzbek government agency. Skytel’s local partner moreover was either unable or unwilling to assist, and didn’t even return the company’s calls. When finally able to set up a meeting with Uzbek officials, Skytel was facing the prospects of a $17 million loss. The senior official with whom the company met offered two options: the official “could personally guarantee that Skytel would be able to use the frequency without interference” for $30 million or the government could buy NCI’s shares at a “significantly reduced rate”. NCI declined and after failing to find another buyer, shut down.” – Muddy Waters, LLC

“Subsequently, MCT, another US telecom operating in Uzbekistan began having problems with the authorities in 2006. In 2007, the US ambassador concluded that MCT – continues to survive only at the pleasure of the Uzbek government. It is likely that authorities are preserving the firm until its assets may be sold to a pre-selected bidder -. The US ambassador leaves no doubt as to the source of MCT’s governmental problems, mentioning Karimova’s personal interest in MCT’s local company, COSCOM. Karimova had told an officer of the embassy “during an impromptu meeting that she wanted COSCOM to be sold to MTS, though she said a Scandinavian buyer would also be acceptable.” – Muddy Waters, LLC

Even though TELIA is partly government-owned, and is the largest publicly owned firm in relatively corruption-free Sweden, The eventual buyer of COSCOM turned out to be TELIA. This has resulted in TELIA quite possibly winning the all-time record for corrupt payments by a western company.

Muddy Waters

In October 2015, Muddy Waters, the US short seller, published a short thesis of TELIA saying that it appears that TeliaSonera made corrupt payments in Uzbekistan exceeding SEK 3.1 billion but that “Uzbekistan appears to be only the tip of the iceberg”. “We estimate — perhaps conservatively — that TeliaSonera could have made corrupt payments throughout its Eurasia and Nepal operations that exceed SEK17bn. In addition, TeliaSonera is potentially obliged to make additional payment to a problematic partner in Azerbaijan of up to SEK7.6bn.

I highly recommend investors to read the short thesis on their own: TeliaSonera_Short_Thesis

Consequences & Major Events wrt. the bribery scandal 

  • In 2012, the anticorruption unit of the Swedish Prosecuting Authorities initiated an investigation regarding the bribery scandal in Uzbekistan. As a result the majority of the board of directors was fired and CEO Lars Nyberg resigned.
  • In September 2012, Uppdrag Granskning publish a documentary which gets widespread attention in Swedish media (highly informative for investors).
  • In 2014, Swedish prosecutors opened an investigation into whether TELIA knew, or should have known, when it bought the license from Takilant Ltd. that the money went to President Islam Karimov’s family. In October 2015, Muddy Waters published their short thesis of TELIA.
  • In 2016 a total settlement of approximately USD 1.4 billion (SEK 12 billion) was reached.
  • In 2017, Uppdrag Granskning publish an additional documentary wrt. the divestment of Ncell.

TELIA has now “decided” it’s exiting all its business in central Asia, including countries such as Azerbaijan, Georgia, Kazakhstan and Tajikistan. The massive settlement of SEK 12 billion (~1/3 of CFO) is still manageable as it doesn’t effect TELIA’s future profitability. The exit from the profitable Eurasia region is worse, as it will depress future cash flows for years to come. The total Eurasia region used to make up ~25% of service revenues and 35% of EBITDA. Eurasia region had as large as double the EBITDA margin compared to the European region, really hurting the company’s profitable growth going forward.

 Divestment progress

*The diagram shows TELIA’s divestment progress of the Eurasia region. The gray bars represent already sold units and the colored bars represent units that are still in operation. The blue bars represent revenue and the red bars represent profit. 

  • In April 2016 TELIA sold its 60.4% ownership in Reynolds holding (who owns Ncell) to Axiata for USD 1030 millions.
  • In September 2016 TELIA signed an agreement to sell its 60 percent holding in Development B.V which controls Tcell.

The first divestiture was its fast-growing Nepalese operation (Ncell). While the company generated a solid financial return from this country, the sale price was disappointed. Nepal had become Telia’s largest market in Eurasia by number of subscribers and was still growing rapidly. 5x EBITDA is too low a multiple for such a fast-growing business. TELIA still holds a majority stake in Ucell in Uzbekistan, where it has faced corruption allegations. It also holds a presence in Kazakhstan, Azerbaijan, Georgia and Moldova through its stake in Fintur Holdings, which it co-owns with Turkcell (not included in the diagram).

When it comes to the disposal of Fintur Holdings, TELIA has guided that it is highly probable that the assets will be disposed during 2017. The timing of the sale of Ucell asset is more difficult to predict. TELIA is currently communicating with the US, Dutch and Swedish authorities in their respective investigations regarding the proposed settlement of USD 1,45 billion. Due to the force divestment, the company is facing significant cash flow issues that implicate both its ability to pay dividends and its credit profile. With these divestitures, Sweden will account for 45% of Telia’s revenue. Sweden has been one of the best-performing markets in Europe, but it also witnessed a slowdown in 2016. Once TELIA has disposed the remaining Eurasia business (inc Turkcell & Megafon), I estimate that 27 % of its consolidated CFO will be lost.

Credit Rating

In September 2016, S&P changed their outlook from “Stable” to “Negative” due to the pending litigation situation with regards to Uzbekistan. The proposed settlement of USD 1,45 billion was already recorded in the books as of Q3 and the process of closing this matter is ongoing. Another area of importance is the current process of disposals, and CEO Johan Dennelind said among other things, that the divestment of Fintur Holdings is highly probable during 2017. The key for credit investors is to try to estimate what leverage the board and management are looking for when the process of divestments come to an end. Within their targeted credit rating range, a BBB+ would mean a notch down from the current rating and that leverage could reach up to around 2.5x EBITDA.

Beyond the presumable credit rating downgrade, TELIA’s balance sheet look rather stable. As TELIA received ~SEK 9,2 billions for selling Ncell alone, Muddy Waters estimate that TELIA will receive approximately SEK 20 billion for the Eurasia region seems to be to low.

It is plausible that the disposal of the Eurasian and Nepal businesses could fetch less than SEK 20 billion in total – particularly given the dearth of credible buyers; existing contingent liabilities; issues with repatriating cash; and, the risk that host governments will either interfere with, or expropriate, these businesses (as has been done before in these countries, including to Telia’s benefit). The more conservative analysts estimate that Telia will receive approximately SEK 20 billion for these businesses, but they appear not understand how widespread the problems are, including in Nepal. – Muddy Waters

The Eurasia region is classified as held for sale in TELIA’s books (SEK 29 billions). If I assume that TELIA will receive SEK 20 billion for the remaining divestment of the Eurasia region and SEK 40 billion for Turkcell & Megafon (~ market value) the company will be left with SEK 54 billion in net debt and ~10 billion in operating leases.

I estimate that the asset remaining after the divestment (excluding Eurasia, Turkcell & Megafon) will be able to produce around SEK 22,5 billion in CFO. Net debt to CFO will then be around 2.5x which is considered conservative for the sector.

Market Outlook

The future sale of the troubled Eurasia activities, will mean the focus is on core Scandinavia. Norway and Finland may report further revenue pressure given lower interconnect fees, though Sweden is also likely to struggle due to weak B2B pricing. Conensus says that domestic competition may intensify with Tele2’s acquisition of TDC, making a further recovery challenging for TELIA. My analysis, however indicates that Tele2 is having fundamental problems which will benefit TELIA in the long run. The Baltic region’s operations were hit hard by the global recession, but they have been the bright spot recently. With mobile penetration rates well above 100%, I think growth will be driven by increased data usage, rather than significant subscriber growth

Economic Moat

Wireless dominates TELIA’s portfolio. The firm serves 19.9 million wireless subscribers in majority-owned continuing operations and an additional 143.7 million in associated companies. By comparison, the firm serves 2.8 million fixed-line phone customers, 2.6 million broadband subscribers, and 1.6 million pay-television users. However, fixed-line and broadband customers typically generate far more revenue and cash flow than the typical wireless account. The Eurasian assets that are for sale are virtually all wireless, so with their divestiture, fixed-line revenue will account for about 32% of the firm’s revenue. TELIA has a moat on the wireless and fixed-line sides because of its large market shares within the countries in which it operates.

TELIA’s size in the wireless business provides the necessary scale to maintain a narrow moat. This scale is particularly important in each country the firm serves, as each country has its own network with its own fixed costs. The more subscribers on a network, the more fixed costs can be spread out, reducing the cost per subscriber. As the largest operator in most of the countries it operates in, the firm should have a cost advantage over its competitors.

The firm is the largest wireless operator in seven of the 13 countries it operates in, which provides a cost advantage over its competitors.

As the incumbent telecom operator in Sweden and Finland, TELIA has dominant share in these countries: In Sweden it holds 62% of the fixed-line market, 39% of the broadband market, and 39% of the wireless market. Those figures are 23%, 31%, and 34%, respectively, in Finland. TELIA is the largest wireless and fixed-line carrier in Lithuania and Estonia, as well as the largest wireless operator in Latvia, Kazakhstan, and Azerbaijan. These emerging markets, coupled with the firm’s core in Sweden and Finland, account for two thirds of sales. In most of its other markets, the firm comes in at number two.

Finland’s fixed-line market is different than most countries, with many municipalities owning their own local network. Sonera is the fixed-line leader in the north of the country, as well as a national leader in wireless. Elisa, the largest Finnish operator, reigns in Helsinki and several other areas. Elisa has also executed a successful wireless strategy, promoting itself as the homegrown Finnish operator while portraying TELIA as the Swedish competitor. The strategy has appealed especially to lower-end customers. Elisa now has more wireless subscribers than TELIA in Finland, though TELIA’s subscribers still generate more revenue. TELIA’s higher average revenue per user demonstrates the firm’s strength with the country’s best customers. In Finland, wireless is more important than in other developed nations. Roughly half of all households use only wireless service, among the highest levels of mobile substitution in countries with a fully built-out fixed-line network. These singular differences are the reason TELIA doesn’t dominate Finland to the extent it does Sweden.

Risk

TELIA faces control issues with its minority positions in MegaFon and Turkcell. Although it has so far avoided legal battles with LetterOne, formerly Altimo, others have not been so fortunate. However, it has had extensive litigation with Cukurova Group, its partner in Turkcell. Other risks include political, economic, and currency issues in developing countries with limited experience in open markets and legal recourse. The firm could also be liable for actions taken in acquiring its operations in Uzbekistan and other countries. With management having announced its intent to exit from Eurasia, it may struggle to sell these assets at a good price. Finally, many of the Baltic countries in which TELIA operates have ties to Russia and could be hurt from continued turmoil in the country, along with its minority position in MegaFon.

Valuation

TELIA will need to consolidate or innovate to obtain a rebound in growth. Traditional telecom business in Europe is facing multiple headwinds. There is little or no growth in Nordic countries and the fierce competition for subscriptions is shrinking TELIA’s margins. In other regions of Europe, there’s opportunities to increase market share and gain new customers in smart phone or content space. Because of the significant headwinds, I will solely value TELIA after its dividend paying potential. I will base my valuation on the gordon growth model, while utilizing scenario analysis with three simple scenarios– a bull case, a base (most likely) case and a bear case – and then extend the discussion more generally.


Bear Case

My bear case scenario will try to simulate the worst possible case, which will enable us to estimate the value at risk. The bear case will attribute zero value to the Eurasia region, and entirely remove the cash flows produced from the Euroasia region. Even if TELIA is expected to divest the Eurasia region this is a very conservative scenario, as TELIA should be able to utilize the cash from the divestments to pursue inorganic growth through M&A. I estimate that ~27 % of 2016 CFO will vanish with the Eurasia regio.

Gordon growth model: SEK 25 (-15 % assuming bought at SEK 30)

  • Assuming a dividend equal to SEK 5,500 millions (SEK 1.3/Share).
  • Requried rate of return of 7%.
  • Dividend growth of 2%.

Base case

My base case scenario will be based on TELIA’s guidance. In terms of financial guidance for 2017 TELIA expects organic EBITDA, from from continuing operations, excluding non-recurring items, to be around the 2016 level. TELIA aim for operational free cash flow(free cash flow excluding licenses and dividends from associates), from continuing operations, to be above SEK 7 billion (from SEK 5.5 billion 2016). This operational free cash flow together with dividends from associates (Megafon & Turkcell), should cover a dividend around the 2016 level. For 2018 and 2019 TELIA aim to further increase the operational cash flow. The dividend level TELIA has guided for is ~SEK 2/share

Gordon growth model: SEK 40 (+33% assuming bought at SEK 30)

  • Assuming a dividend equal to SEK 8,660 millions (SEK 2/Share).
  • Requried rate of return of 7%
  • Dividend growth of 2%

Bull case

The bull case assumes a slight rebound in growth in the long run, which could be made possible by future M&A. Notice that this is still a very conservative bull case as dividend for 2015 and 2014 (SEK 12,990 millions) were both higher than what we assume here (SEK 11,500 millions). The bull case, however, assume that this dividend level is sustainable in the long run, which might be somewhat problematic because of the future divestment etc.

Gordon growth model: SEK 53  (+77% assuming bought at SEK 30)

  • Assuming a dividend equal to SEK 11,500 millions (SEK 2.7/Share).
  • Requried rate of return of 7%
  • Dividend growth of 2%

Here are the corresponding cash flows I assume

 


 

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