Morningstar Advisor - February/March 2010 - 62

Sector Rap 2 Competitive/Regulatory Landscape. How many players are there? How rational are they? Are new players on the way? 3 Economic Efficiency. While average revenue per user is the most commonly used metric in telecom analysis, we also like to look at average margin per user—which focuses on the EBITDA generated by each mobile customer—because firms tend to have more control over costs than revenues. With this in mind, we think the countries that are best positioned going into 2010 are Canada and France. Canada’s cellular penetration rate is only 68% (versus more than 90% in the United States and more than 100% in many European markets), and it is dominated by a very profitable three-player oligopoly. While smaller new entrants are now starting to launch service, they lack the network, distribution, handsets, and finances to compete with the three incumbents. Plus, all three incumbents—Bell Canada BCE, Rogers Communications RCI, and Telus TU—have higher average margins per user than what we see in the United States. AN: Likewise, France has three rational There is some reduction in senior management and possibly some size advantage with dealing with suppliers, but it’s fairly minimal for the larger firms. However, if both operators are in the same country, then there is room for lots of cost savings. Networks can be combined, more calls will stay on the expanded network, reducing roaming and interconnection charges, and staff can be reduced. France Telecom has proposals out with regulators to merge its U.K. operation with Deutsche Telekom DT and its Swiss operation with Danish telecom TDC. We’ve seen consolidation in Russia and Canada. The country in desperate need of consolidation is India, where more than a dozen wireless operators vie for subscribers. HK: This industry requires massive investment. Which management teams have impressed you in how they allocate capital? AN: Telephone companies have historically not IL: Canada’s Rogers Communications offers plenty of value in 2010 for three reasons: 1 Its country and sector strength. We’ve already seen what happens to new entrants who try to disrupt the oligopoly. 2 Rogers’ network is still best-in-class. The gap (over Bell and Telus) has narrowed but not closed. 3 Margin superiority. Margins at Rogers are finally starting to rebound, just when margins at Bell and Telus are set to slide. Canada remains one of the best structured wireless markets in the world. The first new entrant, Globalive, just recently launched service, but it does not have national spectrum to compete cross-country. We expect the firm to go the way of predecessors Clearnet and Microcell. It will run unprofitably for a few years before being bought up by one of the big three incumbents. While Bell and Telus have recently upgraded their networks, Rogers still has more spectrum and cell sites, which ultimately drive network reliability. The buzz around the new networks and entrants should allow investors to grab Rogers at a good price. operators: France Telecom FTE; SFR, which is controlled by Vivendi VIV FRA; and Bouygues Telecom, owned by Bouygues EN FRA. All three have high average revenues and margins per user. However, the high returns prompted regulators in December to award a fourth wireless license. It will take two years for Iliad to build and launch its network, and even when it does, we don’t think it will be nearly as disruptive as most people think. This might provide some attractive investment opportunities in the existing operators’ stocks. HK: Have there been any deals over the past year that you think are truly game-changing? AN: There haven’t been any game-changing been very good capital allocators. Huge prices were paid for acquisitions during the telecom bubble in the early 2000s. When the bubble burst, many firms were left with huge debts, and many smaller firms went bankrupt. Most carriers have new managements and have been more conservative with acquisitions and demanding of potential returns. However, we’ve seen some froth coming back into the market. Telenor TELNY just spent several billion to enter India, one of the most competitive markets in the world. Vivendi also just paid 12 times EV/EBITDA—a ridiculous premium—for GVT, an alternative carrier in Brazil. HK: What about valuations? Are any of your stocks buys right now? AN: France Telecom has been one of my HK: Your team has been picking up several new European firms. Do any of them have economic moats in your view? AN: We think Swisscom, Belgacom BELG, and TeliaSonera all have narrow moats. Swisscom has one of the strongest moats in the telecom universe we cover. Switzerland has three operators, and if France Telecom and TDC succeed in merging, it will be a duopoly, possibly the only one in a developed market. In addition, it is a very wealthy country where people are willing to pay up for quality and prefer to buy local. Swisscom has a superior network with greater coverage and faster speeds. At a cheaper price we would love to own this company. K Haywood Kelly, CFA, is vice president of equity research at Morningstar. deals, but we’re seeing more in-market mergers. We expect this trend to continue. When two firms in different countries merge, there isn’t much room for cost-cutting. favorite stocks for some time. It has been in and out of 5-star territory recently. Not only is it the leader in the French wireless market, it is leading in-country consolidation in Europe and has significant assets in Africa, providing some growth. It also pays a gross dividend of almost 7% (before 15% foreign tax withholding). 62 Morningstar Advisor February/March 2010

Morningstar Advisor - February/March 2010

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