The year 2010 was a banner one for Israel’s cell phone industry and its shareholders: Profits soared, share prices reached record highs and controlling shareholders were milking the companies for cash at full force. But the winds of change were gathering.
In the summer of that year a battle raged over the government’s plans to reduce interconnect fees and by the end of the year it was already clear that Moshe Kahlon, communications minister at the time, was getting set to institute revolutionary changes.
Few, however, correctly priced the growing risk factor and in December that year the stock prices of Cellcom Israel and Partner Communications − the latter popularly known as Orange − reached their peaks, only to rapidly crumble since then. To the dismay of investors, not many equity analysts predicted the impending momentous change.
The most prominent of those who saw it coming and sounded the alarm was Citigroup analyst Michael Klahr, who lowered his recommendation on Cellcom to Hold in November 2010, a month before it peaked. As for Partner, Klahr went out on a limb and gave it a Sell rating − a rather uncommon move in the local market. “The shares are gaining but the risk is growing,” he titled his report.
Two-and-a-half years later, with mobile stocks trading 75% below their peak values, Klahr is again going against the tide. While a number of analysts have gone back to recommending the mobile providers on the assumption that their shares have reached rock bottom, Klahr is still taking a bearish view of Cellcom and Partner’s emerging from the depths. And while in recent weeks the stocks have turned around and soared about 80% above their lows, Klahr still maintains a Sell on both of them.
“Over many years local investors treated the cellular operators as consumer goods companies and attributed too much value to their brand names. At Citi we have treated these businesses as infrastructure companies with the understanding that the main risk they face is regulation,” Klahr says, explaining his different approach.
“The return on equity we expect from infrastructure companies is also lower than what we demand of consumer goods companies, so we saw an unnatural gap had opened up between their market value and our valuations. It could be foreseen that the gap would close over the long run. The main factors that reduce such a gap are technology, regulation and competition, although it’s easy to say this now and much harder to identify in real time.”
Klahr finds similarities between what’s happening now in the cellular market and what occurred some years ago when Rami Levy entered the retail food arena. “For 15 years Mega and Super-Sol held regional monopolies until Rami Levy arrived opened a cheap store nearby,” he explains. “The old-timers were stuck with gigantic stores and expensive long-term lease commitments. Their fixed costs were high and they couldn’t react.”
Klahr also equates the perceptions of cell phone company customers with those of supermarket chain customers. “Golan Telecom struck a deal with its customers much like the one made by Rami Levy: ‘I will always be the cheapest.’ The consumer doesn’t keep checking this out but simply knows that both are the cheapest and therefore saves himself from deliberating. Golan didn’t offer just low prices but also simplicity.
“The consumer no longer needs to check the bill worrying that he was overcharged or hit with unfamiliar costs,” continues Klahr. “This builds trust with the customer, something that’s missing in the relationship between the older cellular operators and the consumer. That’s also the reason Golan won’t raise its prices. It simply isn’t playing on the same old field as the older companies. Their cost structures aren’t suited to average monthly revenues per user of NIS 75. They will always strive to raise prices.”
The feeling among some investors is that the ruthless competition between cellular companies will soon ease up. Do you share this feeling?
“People look at the three strong companies and think that the way things were will continue to be so for years to come. When a new competitor enters a field people generally don’t understand its intentions. After meeting Michael Golan I can say he has business strength that places him at an advantage over the three existing operators.
“They say Golan won’t be around in another year, that he isn’t profitable, and that he’ll get back part of his guarantees and then change the way he competes in the market. This is nonsense. Nobody can know what he will do. He’s building a business from scratch. This is the incredible advantage he has over the existing operators that are still loaded with many expenses and past investments. Golan has successful experience in entrepreneurship, he’s smart, and he has strong owners backing him.”
One of the main claims heard among people in the cell phone industry is that demand in Israel can’t support many companies with an independent cellular infrastructure for long, and that one of the current players will likely exit the industry in the medium to long term − apparently Golan Telecom according to them. Klahr doesn’t agree, believing that the current situation will continue over the long run considering the relatively low investment needed to establish a cellular network in Israel, and the return on equity that private shareholders are likely to demand from these companies.
‘Room for more’
How many cellular networks can operate in Israel simultaneously?
“There is no correct number of operators in any market. Just because we’re used to three operators in Israel doesn’t mean that that’s the right number for the local market. The question that needs to be asked is how many operators can reach a decent return on investment in Israel, and the answer depends on the amount of investment needed to set up a country-wide cellular network. With Israel’s size, population concentration and topography, the scope of investment is comparatively low, reaching in our estimation just around $500 million. So a shareholder demanding a 15% annual return on his investment will need an annual cash flow of $75 million.
“The veteran Israeli operators, however, each generated $140 million to $150 million in available cash flow last year, so there is room for more operators in Israel. The number of financially viable operators will rise as newer investors coming in demand lower returns. In Britain and Austria, for example, investors demand returns of just 7% to 8% on their investment in cellular companies. In the long run Israel will likely have four or five operators with their own networks such that each will hold a 15% to 25% market share.”
Klahr says he thinks Golan has the chance increase its market share beyond 7%, the share at which he can get back all his guarantees. “If I were him I wouldn’t stop at 7%; I’d aim for 15%, depending on how much money he has, but he says he’ll be already be profitable at 7%. If you’re a private company, without investors from the public, you’re more flexible on the return you require from the business. Golan can build its business model on a long-term return on investment: It all depends on its horizon. As a long-term investor it can manage with a lower return.”
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