Call Telmex to Collect Big Returns
Here's my latest write-up. Enjoy and let me know what you think.
Company: Telefonos de Mexico aka Telmex (TMX)
Price: 36.74 (11/30/2007)
P/E ratio: 12.49
Telefonos de Mexico aka Telmex (TMX) is Mexico’s only nationwide provider of fixed-line local and long distance telephone service and Internet. The company also offers telephone, television, and Internet service in a number of Latin American countries. TMX recently announced that it will spin off its international operations in early 2008. The spin-off, Telmex International, will be a fast growing company with operations in Argentina, Brazil, Chile, Colombia, Ecuador, and Peru. Telefonos de Mexico will retain the Mexican fixed line telephone and cable operations.
I believe that the spin-off of its international operations will enable Telmex to unlock the true value of this portion of its business. Once it is on its own, the market will likely eventually assign a much higher multiple to the fast growing Latin American play than the one that the company as a whole currently trades at. For the most part, the economies of the Latin American countries that Telmex International serves are improving and they all have relatively low penetration levels for data and voice transmission services, so the company will have a lot of room to grow. To illustrate, according to internetworldstats.com (check) Latin America currently only has about 20% penetration for Internet usage, versus 70% in the United States.
Not only will Telmex International’s high growth rate be more apparent after the spin-off, but the move will free it from the pressure that the recent anti-trust actions that the Mexican government has taken against Telmex have been putting on the company’s stock. This is a very similar situation to how the scheduled spin-off of Philip Morris International will free it from the constant threat of litigation that Altria faces in its home market. As an added bonus, the new company's management will be able to focus its full attention on growing its Latin Alerican operations without the destration of trying to revive its Mexican operations.
The last time that Telmex spun-off a division it worked out pretty well for shareholders. The Company spun-off its mobile phone operations, America Movil, in late 2000. After falling to a low of around $4.50 per share in July of 2002, today America Movil trades at $62.10…an increase of 1,280% in a little over five years.
About TelMex International
Telmex International provides data, Internet, and voice service in Argentina, Brazil, Chile, Colombia, and Peru. It also offers cable television service in Brazil and Colombia and telecommunication services in Ecuador. Year-to-date operating income for TelMex’s non-Mexican operations is up over 75% versus the same period a year ago.
The crown jewel of TelMex International’s operations will be Embratel, a fixed line and Internet services provider in Brazil. Telmex has been transitioning Embratel from a traditional long distance company to one that provides integrated telecommunications services. Long distance now only accounts for slightly more than half of the division’s revenue (54%) versus 65% during the same period in 2006. In fact, Telmex's Brazilian revenue increased 37% overall in its recent third quarter as a result of increases in sales of telephone and high-speed Internet service through the company’s joint venture Net Servicos de Comunicacao (Telmex owns 49%). Net Servicos’ sales of broadband Internet service soared 71% during the recent quarter.
Not only is the company's top line growth increasing rapidly, but its margins are growing as well. This eventually will translate into some stellar earnings numbers. As Embratel’s customer base continues to grow and it adds new services like Net Fone (VOIP), it will be able to leverage the network that it has built to improve its margins. The Company’s EBITDA margin in Brazil is currently 26.4%. Up from for the nine months it was 25.8%.
Telmex International is also rapidly expanding its operations in other Latin American countries. On October 10th, the Company finalized its acquisition of Cablecentro and Satelcaribe in Colombia, adding them to its existing Cable Pacifico, TV Cable, and Superview, cable TV properties. Telmex’s new Internet and cable television operations nearly tripled its revenues in Columbia versus the same period a year ago. Of course, rapid growth comes at a cost. Telmex’s expenses increased as it integrated its new TV companies and added salespeople to try to promote its products to small and medium sized businesses. These expenses will decline as Telmex integrates its recent acquisitions and it increases its customer base. During the quarter, the Colombian operations reported an operating loss of 7.726 billion Colombian pesos compared with operating income of 10.228 billion Colombian pesos a year ago, but these numbers are deceptive because a large portion of the loss was a result of higher depreciation charges related to the updating of its new cable infrastructure. In Q3 EBITDA in the country was 20.793 billion Colombian pesos, compared with 18.636 billion Colombian pesos in the same period of the previous year. The EBITDA strength is encouraging, and we will see Telmex's 16.3% margin in the country continue to expand as it integrates its new acquisitions and adds subscribers.
Revenue from Telmex International’s Argentinean operations rose 15.0% versus the same period in 2006 on the strength of its Internet and local telephone business. Its third quarter expenses rose 11.6% due in part due to the Company’s expansion efforts. In the quarter, EBITDA totaled 20.2 million Argentinean pesos, an increase of 57.8% compared with the same period of 2006 with a margin of 19.8%. Operating income rose to 2.4 million Argentinean pesos in the quarter compared with a loss of 0.6 million Argentinean pesos in the same period of the previous year.
Telmex’s Chilean revenue grew by 11.9% during the most recent quarter with increased Internet (+8.1%) and local services revenues (+40.2%) offsetting a small (9.9%) decline in long distance revenue caused by consumer migration to mobile services and private networks. Again, expenses in the country rose by 11.0% during the quarter, primarily as a result of expansion efforts. Commercial, administrative and general expenses increased 10.3% as a result of the launch the Company's new WiMax multi-service packages. In the quarter, Telmex's operating loss in Chile dropped to 772 million Chilean pesos versus a loss of 823 million Chilean a year ago. EBITDA totaled 2.431 billion Chilean pesos with a 13.0%.
The company’s revenue in Peru in rose 23.8% in the third quarter. Chile's data business (which currently accounts for 36.1% of the area's total revenues) rose 36.0%. During Q3 Telmex's costs and expenses in Chile rose dramatically of line expansion and the integration of its cable television companies. EBITDA totaled 14.2 million New Soles, 9.0% lower the same period of 2006, with a margin of 21.5%.
The company is just getting started in Ecuador. In March 2007, Telmex acquired Ecuador Telecom (Ecutel), a company that provides telecommunication services to corporate clients and to small- and medium-size companies in Guayaquil, Ecuador. This is a great potential market for Telmex as well. As of the end of 2006, only 8% of the Country's population had Internet access.
Case for keeping the parent company after the spin-off
Even though I believe that Telmex International is much more attractive than Telmex’s Mexican operations, a case can be made for keeping both parts after the separation is complete. Telmex owns an astounding 90% of Mexico’s phone lines. This is a good and a bad thing. It's good because the company generates a ton of revenue and has great cash flow. It's bad because Mexican regulators plan to start a probe by the end of the year to identify parts of the country where Telmex's market share is high enough that it may have to take action to increase competition.
Furthermore, the Company’s growth in its home market has been stagnant for the past several years and it will likely face additional downward pressure if the government achieves its goal of increasing competition. Even so, the Mexican operations still generate a ton of money. They account for more than 70% of the combined company’s total revenue and it has tremendous cash flow. It has been using this tremendous cash flow to pay a solid 2.3% dividend and to buy back shares. In 2006, the company spent approximately 24 billion pesos to buy back its stock. These purchases have continued in 2007.
Better yet, the Telmex's stock is relatively cheap. With a P/E ratio of 12.49 it currently trades at a discount relative to other companies in the telecom industry, such as AT&T (20), SK Telecom (13.5), and BCE (13.71).
Telmex’s Mexican operations have a number of opportunities that can help it to slow or possibly even reverse its trend of declining revenue.
Rapidly Growing Internet Business
The company has been increasing its sales of Internet service in Mexico and it will continue to do so. In Mexico, only approximately 20% of households currently have computers that can be used to access the Internet. This number will continue to grow with the growth of Mexico’s middle class. Mexico has one of the highest growth rates in this type of service among the countries that are members of the 30 countries in the Organization for Co-Operation and Development (OECD Communications Outlook 2007). Of Mexico’s estimated 3.1 million internet users, 85% are use Telmex’s broadband Infinitum service.
For the past year, Telmex has been remodeling its company stores in an effort to increase their business. It seems to be working, during the third quarter the Company’s earnings from “other revenues” (primarily reflecting the contribution of TELMEX stores and Yellow Pages) rose 34%. Year-to-date, Telmex has sold 240,000 computers through its stores. Not only do these sales generate revenue, but they encourage Internet usage.
The introduction of Internet television is another potential growth driver for the Mexican operations. Once the government’s anti-trust case against TelMex is cleared up, most likely some time in 2008, it should receive the go ahead from regulators to begin offering Internet TV.
As with any investment, there are risks associated with purchasing Telmex stock before the spin-off is completed. The company continues to lose business to the mobile phone market. Moreover, the Mexican government is trying to increase competition. Of course, there's the risk of a significant downturn in the Mexican economy to consider as well. Still, the benefit of being able to get into the Telmex International spin-off on the ground floor probably makes purchasing TMX stock today worth the risk.