Let’s take a quick look at Israel’s largest wireless telecommunications company, Cellcom Israel (NYSE:CEL), which is in our StrataGem list this month. It should be particularly attractive to income-oriented investors as the foreign carrier pays a hefty 11.4% dividend and has generated consistent cash flow for years. Also, it’s been beaten up a bit on the developments in Egypt, which ought to subside and lead to a reversal higher.
Since going public in 2007, the company has outclassed its American counterparts in the hearts of investors, rising 150%, as shown below, due largely to its much faster growth rate, at 17% per year. Despite this big run, it is still cheap, trading at 9 times trailing 12-month earnings — that’s a nice combination.
Based in the town of Netanya — halfway between Haifa and Tel Aviv — Cellcom has 3.3 million customers and 34% of the Israeli telecom market. Its largest competitors, Partner Communications (NASDAQ:PTNR) and Pelephone, control 32% and 29%, respectively. Niche provider Mirs has the remaining share and provides service for the ultra-orthodox Jewish population known as the haredi.
Before 1994, cell phone usage was limited in Israel due to high costs and poor service. Cellcom was established in that year and began offering affordable phone plans that ignited demand for mobile phones in the highly urbanized country.
Israel now boasts one of the highest levels of mobile penetration, with 127.5 phones per 100 inhabitants. Further revenue growth will come from increased value added services such as access to mobile Internet, ringtones, text messaging, mobile wallet and video games. These premium services have a much higher margin than traditional voice service and will allow Cellcom to increase profitability despite Israel’s high saturation of usage.
Subscriber growth was moderate at 3.6% year over year in 2010, but high-speed subscribers increased 18.4% to 1.1 million. Revenue from data and text messaging jumped 24.9%. With only one-third of its customer base using smartphones, Cellcom has plenty of room to increase revenue from voice-only customers.
While Cellcom is not a dashing new technology company, the carrier is an extraordinary cash flow machine. It boasts 40% gross margins and the firm’s operating margin increased 3 percentage points compared to last year. Free cash flow jumped 13% while earnings rose 9.3% year over year.
Its borrowings, at $1.2 billion in debt vs. $320 million in cash and equivalents, are hefty but should not be problematic due to that ample cash flow. Earnings covered its interest expense by 6.8x. Getting away from all the mumbo jumbo, this all just means the company is in good financial health.
CEO Amos Shapira has done an impressive job of creating value for shareholders. Dividends have grown 39% in the past three years to $3.58 a share, and profitability increased during the global recession.
Israeli regulators have created a very competitive business environment for carriers that has slowed revenue growth. Subscribers can switch carriers without losing their original number, which has reduced the Cellcom’s pricing power.
Plus, the government reduced the interconnect rate by 73% in January 2011. This rate is the fee that carriers can charge one another to connect subscribers between to their mobile networks. This fee is significantly below the Eurozone average of 0.06 euros and is expected to reduce Cellcom’s net income by $85 million a year, according to a company statement.
Moshe Kahlon, the communications minister, is also pushing for the entrance of mobile virtual network operators, known as MVNOs, into the Israeli market. These smaller carriers have no network of their own; they buy capacity at a wholesale rate from providers like Cellcom and then sell it at a retail rate to subscribers. The government has received applications for 12 MVNOs and expects these smaller carriers to grab a 7% market share or 630,000 customers from Israeli’s three big carriers.
Given the level of mobile penetration in Israeli, new entrants face stiff competition. In my opinion, Cellcom is well entrenched with its own 3G network, strong brand name as the largest carrier in Israel, and a vast sales force and customer service team.
Analysts expect Cellcom to earn $3.01 in 2011, which is actually 9% lower than 2010 fiscal year estimates. This peculiar situation has developed due to the recent regulatory changes and provides us with an excellent opportunity. Downside risk has already been factored in the price, and there is a lot of upside if the carrier beats estimates, which CEL has done by an average of 11% over the past five quarters.
It’s impossible to talk about investing in Israel without considering the political risk. Instability in the region could turn a pro-Western dictatorship into anti-Israeli democracy that threatens earnings potential in companies like CEL. I don’t think the turmoil will destabilize the region, but it is one factor keeping the price of the shares down in the past month. .
Top-line growth will remain mild, but as subscribers demand high-quality broadband service to access the mobile internet, Cellcom Israel’s profits will increase. I expect the firm to beat estimates and lift earnings to at least $3.40 a share in 2011. Applying a 12x P/E multiple, we’re looking at the potential for a $41 stock that pays an 11.4% annual dividend.
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