Blogvesting

After reading about Rogers Communications from TMWTFS, I decided to evaluate if RCI is a possible defensive portfolio holding in these turbulent times. Rogers Communications (RCI) is an integrated telecommunications company based in Canada, and has 3 operating segments, wireless, cable and media. Their wireless segment makes up 50% of revenue, and 70% of operating income, and is the chief driver of earnings growth, and so I’ll be devoting all of my analysis to the wireless segment. In addition, all numbers quoted in this article is in Canadian dollars, unless otherwise explicitly stated.

Among the telecoms in Canada, Rogers is considered the top-of-the-line company, boasting the fastest network speeds, and charging premium prices for their products. Rogers has the only GSM network in Canada; the other main carriers, Telus and Bell, both use the older CDMA network. For a variety of technical reasons, the GSM network is heavily preferred by end-users, and most new handsets today are made for the GSM network, Due to its monopoly in Canada, the ARPU (average revenue per user) for Rogers customers is a staggering 20-25% above that of other comparable telecoms in developed economies. Because it is the only GSM carrier in Canada, it has won the Apple iPhone franchise by default.

The telecoms business is both operationally and financially leveraged. Telecoms usually incur substantial debt during the build-out of their infrastructure. After that, once the fixed costs of infrastructure maintenance and debt service are covered, marginal increases in revenue translate to dramatic increases in earnings. To obtain this high desirable revenue growth, telecoms spend heavily in advertising to capture additional consumers. Consumers typically switch carriers for some combination of three reasons: lower cost, faster speed, or a highly desirable handset. Since Rogers has both faster speed and the lion’s share of new handsets, it has commanded a higher growth rate then its competitors, with revenue growth of 12-15% annually, and much higher earnings growth.

Due to its GSM monopoly, Rogers is nearly universally loved by stock analysts, who point to the long-term contracts (typically 3 years duration) as a source of steady cash flow, and nearly universally hated by consumers, who dislike the expensive rates and the various fees levied by Rogers. After numerous complaints, Canadian regulators have recognized the need for competition in the telecoms industry, and have mandated that new entrants to the industry be given roaming access to their competitors’ networks at commercial rates, with compulsory arbitration to establish the rates if an agreement cannot be brokered. In addition, both Bell and Telus have seen the writing on the wall and probably will eventually transition to a GSM network. While GSM is open-sourced and free, CDMA is patented by Qualcomm, and both telecoms and handset manufacturers have to pay royalties to Qualcomm. This is especially aggravating to handset makers, who operate on razor-thin margins in a highly competitive environment and view paying royalties on every chip used in a handset as a form of extortion, and thus almost all new handsets are now based on GSM. In addition, nearly all newly established telecoms in the developing countries have chosen GSM as the standard, and about 85% of the world’s networks are GSM-based, further establishing a large market for GSM phones. Therefore, I consider it highly likely that both Bell and Telus will at some point transition to GSM, and Rogers is likely to face increasing erosion of its monopoly in the future. Already, Rogers has announced that it will eliminate its system access fees for the relaunch of its Fido product.

There are many things to like about Rogers. Firstly, management is clearly shareholder-oriented and offers a high and increasing dividend. I also like that they placed the value of their stock options on the balance sheet as a liability so that they can settle options exercises on a cash-basis using pre-tax cash flow, therefore taking a one-time earnings hit so that they can essentially repurchase shares using pre-tax dollars. Only a company concerned about share dilution will make such a move. Secondly, the company has a enviable competitive position, with most of its customers locked up in 3 year contracts, and having secured the iPhone deal. However, there are also worrisome issues. The company spends substantially on acquisitions without articulating a clear strategy. In 2008, it spent $1 billion to buy some additional wireless spectrum in a national auction, and in 2007, it spent $405 million to acquire 5 Citytv stations. While acquiring additional spectrum is clearly beneficial to Rogers, it seems questionable to me to be spending $405 million on TV stations. Certainly, management did not bother to elaborate on the rationale for the acquisitions, or the expected returns. Rather than spend money on TV stations, I think it would be preferable to be spending money on research and trials of 4G networks, (LTE and WiMAX), so that Rogers can maintain its technological edge over its rivals in the future. In addition, the current economic climate clearly favors Rogers’ competitors. Rogers is likely to face increased turnover of its customers who are unhappy about the exorbitant rates (the 3 year contracts can be terminated with a maximum of $400 in cancellation fees), while Bell and Telus are likely to gain traction with their cheaper products.

Rogers has $8.5B of debt at an interest rate of around 7%, incurring interest expense of $500M annually. For fiscal 2008, Rogers is guiding for revenue of around $11.4 billion. With about $8.6 billion in fixed costs, this gives an operating profit of $2.8 billion, which after $550 million in interest and a 35% tax rate gives $1.4 billion in earnings, or about $2.20 EPS. If Rogers continues on its 10% (or better) revenue growth, earnings will skyrocket to $2.1 billion in fiscal 2009, or an EPS of $3.30. If revenue growth is reduced to 5% or 0%, 2009 EPS will be around $2.80 and $2.20 respectively. I personally think that a reduced revenue growth rate of 5% is the most probable scenario over the next few years. The PE multiple to apply to a given EPS is a matter of personal taste (what discount rate to use, how risky you think the business is etc.), but I personally would assign a conservative PE of 12 to 14 for a blue-chip like Rogers, making the stock worth $33 to $40, making it modestly undervalued at its current price of $32. In the worst case scenario, revenue is flat and the PE shrinks to 10, which gives Rogers a valuation of $22 per share. I think that the margin of safety would be adequate at any price below $27, which gives a greater upside than downside.

I have sold some Jan put options for RCI at a strike price of US$22.50 (approx C$27) for US$1.10. This translates to a 4.9% return over about two months (assuming the options don’t get exercised). Over the long-term, Rogers will face increasing pressures on its profit margin, but has a reputation for quality (but pricey) products and is backed by hard wireless spectrum and cable assets, which makes it a valuable company at an appropriate price.