In terms of market share, South African telcos are usually either in first or second place in the emerging markets in which they do business. They are well-invested and cash-generative, and historically, with strong balance sheet management, they’ve provided more than reasonable returns.
These positive dynamics have deteriorated somewhat of late, however, mainly due to currency drag and regulatory issues in some emerging markets. While one can adjust for these factors as one-offs, which would make for better optics, this doesn’t mitigate the forecast risks. South Africa’s two biggest telcos, MTN and Vodacom, both have significant operations in other emerging markets. In fact, Vodacom has only 50% exposure to South Africa, while MTN has even less at 30%. This means that these telcos are unlikely to rally meaningfully alongside SA Inc stocks (companies that earn most of their income in South Africa).
OPPORTUNITY – AND CHALLENGES
Emerging markets such as Nigeria, Egypt and Ethiopia are an attractive growth opportunity for South African telcos because of the structurally low data and smartphone penetration in these markets – well below global averages. The potential upside for telcos is compelling enough to envisage a multi-decade growth story.
The economic and regulatory challenges in these markets have proved daunting, however. Currency volatility has led to several pronounced instances of hyperinflation, making it difficult to run a business in these countries, since cost structures are typically in hard currency. For example, the lease costs of telco towers are often mainly in US dollars.
Since prices are regulated in many emerging markets, telcos aren’t able to push increases through to customers in time, or at all, impacting turnover. Group turnover for both Vodacom and MTN seldom consistently beats CPI inflation growth in South Africa, so cost management is key to growing profits. With pricing constrained, volume growth is expected to do the legwork. However, in this area, the growth of data is somewhat offset by the decline in voice.
RETURNS VS COST OF CAPITAL
It is generally believed that smartphone and data penetration in emerging markets will start to approach global averages in time – but the process won’t be linear. In the meantime, to hold traffic and grow capacity, the telcos need to invest in assets such as spectrum, networks and towers. These aren’t inherently capital-light businesses. However, the returns on the invested capital still need to justify the amounts spent.
In developed markets, telcos tend to rerate (investors are willing to pay a higher price for shares) when returns on all invested capital meaningfully beat the weighted average cost of capital. Both MTN and Vodacom have seen a marked decline in returns on invested capital versus the cost of capital over the past 10 years. While the companies aren’t loss-making, very little economic value is being added. It is for this reason that South African telcos are currently cheap and have been so for a long time.
VALUE TRAP
From a total return perspective (i.e. when you include both share price movements and dividends received), our telcos have underperformed both local bonds and even money markets for well over a decade. When one considers that South African bonds, at current levels, are seen as cheap, local telcos are ‘that much cheaper’ – in other words, a value trap.
Even with risk-adjusted sensitivities and scenarios, there is copious fair value upside, but the inherent value will remain ‘trapped’ until the noise from emerging markets dies down and we start seeing sustainable returns. Nigeria and Ghana (MTN), and Egypt, Ethiopia and Kenya (Vodacom) have all experienced currency blowouts, which impacts not just in-country working capital but also the repatriation of funds. This makes the earnings stream volatile with high forecast risk and therefore of lower quality.
In summary, while there is a broad structural growth story for South African telcos, the lack of sustained returns versus the cost of capital remains the most significant challenge for these companies. It will be a while yet before our telcos rerate, and when they do, this will be linked to returns on all invested capital faring that much better than capital’s own cost. This will be our ‘dial tone’ to consider an investment in this industry for our clients’ portfolios.
