The Stock

What to Buy: Cellcom Israel Ltd (NYSE: CEL) @ 32.50

Why Now: Cellcom Israel is the largest player in a mature, competitive domestic wireless market. It continues to improve the quality of its subscriber base–moving users from “pre-paid” to “post-paid” status at a solid clip–and to find efficient ways to increase cash flow while reducing costs. All that and a double-digit yield add up to an attractive package for investors who are willing to take on risk but want to get paid a reasonable dividend to do so.

Cellcom and its peers in the Israeli wireless market face the threat of continuing “airtime price erosion” because of efforts by the government to bring down costs, and a February license auction means more players in an already tight game. But Cellcom should be able to use its position to continue to grow its payout, and with that share-price gains will follow. It’s come well back from a steep summer 2010 selloff, but there’s upside and it still yields north of 13 percent.

The Story

David: Do you recall the Israeli wireless operator we talked about a few months back, Cellcom Israel Ltd (Tel Aviv: CEL, NYSE: CEL)?

Big yield, but, man, that’s one difficult domestic market.

Roger: Well, yes, I do remember Cellcom and its big yield. And I am familiar with the, uh, unique characteristics of the Israeli mobile market.

David: OK, let’s start with the saturation.

Roger: I thought you’d focus on the regulatory climate. But saturation is an important point.

The mobile phone penetration rate in Israel–home to about 7.6 million people–is about 125 percent. That’s one of the highest rates in the world. But as saturated as it is, it’s pretty competitive, too. Cellcom is the biggest of four network operators, with 3.376 million subscribers as of the end of the third quarter of 2010.

David: And the government is doing everything it can to birth another wireless operator, with average revenue per user (ARPU) figures already dropping for the incumbents.

We cover Cellcom’s primary competitor, Partner Communications (NSDQ: PTNR), in Utility Forecaster. As for the others, Pelephone is a unit of former landline monopolist Bezeq Israeli Telecommunications Corp (Tel Aviv: BEZQ). Mirs Communications is a subsidiary of privately held Altice Group, notable for its exclusive arrangement with the Israeli Defense Forces.

You’re not exactly bullish on Partner, assigning it a UF Safety Rating of 2 and calling it a “sell.”

Roger: Partner has issues, including the fact that, despite third-quarter cash flow growth of 12.5 percent and revenue growth of 4.8 percent, churn was up to 5 percent. “Churn,” as you know, is the telecom industry term for customer turnover, and here it suggests that Partner has too many pre-paid users. Post-paid subscribers–those who sign long-term contracts–are lifeblood for wireless providers.

David: And its third-quarter payout ratio was 98 percent, which is on the aggressive side. But Cellcom paid out 120 percent of net income in the third quarter to shareholders. Isn’t that a little too aggressive?

Roger: I can tell by your tone that you’re about to try to roll me with your skepticism. But, No. 1, let’s remember what we’re doing here, and that’s finding big yields. No. 2–and of utmost importance–we’re not just throwing money away here, chasing after an attractive number. We are balancing known risks against how we’re compensated.

There are razor-thin differences, even outright favorable comparisons for Partner, and both have relatively high debt, if you compare to what we’re used to seeing for the major US telecom service providers.

But Cellcom is paying more. Using its most recent declared dividend and based on yesterday’s (Jan. 19) close, Cellcom has a reported indicated gross yield of 13.84 percent. Partner, on the same basis, is yielding 10.55 percent.

Both management teams have boosted payouts as overall wireless penetration has increased in Israel; Cellcom has raised its dividend by 30 percent over the last three years. And it’s generated free cash flow per share of 5.57 Israeli shekels (ILS) per share over the trailing 12 months, nearly double Partner’s.

Cellcom’s risks are accounted for by a regular payout that, based on recent history, is more likely than not to grow, even considering government attempts to stoke competition and drive down customer rates.

David: OK, when do I ever “roll” you? And without abandoning my “skepticism,” I’ll admit I’m impressed by the fact that Cellcom’s churn rate in the third quarter was 4.6 percent, down from 4.9 percent a year ago and obviously better than Partner’s.

I like that it’s the biggest player in a mature market; I’d rather be Cellcom than the newcomers the Israeli government is attempting to escort into the market. Cellcom has a huge footprint–its network covers all of Israel, it operates 400 hundred stores and service centers all over the country, and it employs more than 3,000 people.

And Cellcom added 35,000 subscribers during the quarter, all of them, according to management, postpaid. The subscriber base increased 3.6 percent year over year.

Roger: The extent of its network is an important factor that’s worthy of a little extra scrutiny, because it could be an important growth driver for a company that’s competing in what we’ve acknowledged is a saturated, mature core market.

A couple years ago Cellcom decided to use the fiber-optic network it laid for the primary purpose of connecting its wireless towers to provide fixed-line services to industrial customers–it happened that the fiber-optic network basically overlapped with key industrial centers in Israel.

Now, Cellcom is not likely to offer “quad” packages or any kind of super-bundles to consumers.

Its infrastructure isn’t set up to accommodate that kind of effort right now. What it can do is leverage existing infrastructure to offer new services that generate new revenue, in effect driving down costs. Although because of regulatory restrictions Cellcom can’t right now become an Internet service provider (ISP), its fixed-line network makes it possible down the road. Solid free cash flow growth of 13 percent in the third quarter, extending the trailing 12-month FCF strength I mentioned earlier, means Cellcom can fund such efforts internally.

Size and scale are the name of the game, even in a relatively small market like Israel’s.

David: Alright, sold: These guys know what they’re doing. I’m still concerned about the Israeli government and the whole the-power-to-tax-is-the-power-to-destroy thing. The government announced in September 2010 that it would enforce new reductions in the amounts mobile network operators can charge as “interconnect tariffs” for the use of networks by non-subscribers. The first reduction is effective this month. This seems, given the extent of Cellcom’s network, a targeted attack.

And in November Israel’s Communications Minister asked the country’s Antitrust Authority Commissioner to look into possible anti-competitive behavior, by the top three telecoms, specifically the fact that all three announced similar rate increases within days of each other.

Roger: Cellcom, and its peers, have dealt with an intrusive government for some time now, and they’ve adjusted, Cellcom better than the others. This is business; it isn’t personal, and Cellcom understands that. In response to the government’s move the three big service providers did announce price increases, and Cellcom will be the first to implement its plan.

The company will boost usage fees in some of its packages and rates for subscribers who have no commitment period. The average hike is 4 percent, though the increase for some plans will be as much as 20 percent.

It’s important to note as well that in other jurisdictions where government has attacked incumbents in similar ways those same governments have eased up once they’ve established a level of competition they’re happier with. And they’ve shown themselves to be friendlier in other areas, such as expanding into new businesses.

David: It’ll be interesting to see the impact of these increases on first-quarter 2011 numbers. As for another customer satisfaction issue, Cellcom had a 12-hour service outage in December that prevented most of its 3 million-plus subscribers from communicating; that’s got to be a problem for the fourth quarter.

Roger: To say this half-day outage “prevented…subscribers from communicating” is laying it on a bit thick; you’re too old–40 now, is it?–to act as if your life depends upon the network.

Anyhow, Cellcom did have a serious outage. And it responded in a serious way: It refunded its subscribers the costs of all calls and texts for the week that began with the outage. The move will cost about USD37 million, but it is money well spent if you consider, again, the key metric of churn: Cellcom has to mitigate any problem that could result in an increase in customer turnover.

That’s going to hit earnings, but not by as much as some dramatic figures thrown around in the speculative media. And it was an absolutely necessary step, from the perspective of retaining your post-paid subscribers. Think of it as “churn mitigation.”

David: So the key for Cellcom seems to be to convert pre-paid into post-paid subscribers, hold onto them and pile up “recurring revenue from minutes of use.” That part of the business grew by 1.1 percent in the third quarter, all things–subscriber additions and government takeaways–considered. Overall revenue was up 3.2 percent, and that figure was juiced by 25 percent growth in revenue from content and value-added services such as music and video downloads.

What’s the word on the Street?

Roger: Two analysts call it a “buy,” 17 say hold. The stock is trading in a range that puts it right up against most analysts’ 12-month targets. Given the recent track record of dividend growth, however, we’re likely to see a boost that catalyzes a run up for the stock price.

David: It’s pretty clear that the current payout compensates us well for any risks. At this point I will abandon my skepticism.

Roger: OK, but don’t surrender completely. I advise anyone buying this one to check out the company thoroughly and get a little more familiar with the operation.

David: Cellcom is based in Netanya, Israel. The stock trades on the New York Stock Exchange (NYSE), so it makes regulatory filings in accordance with US Securities and Exchange Commission requirements. More information about the company is available at http://investors.ircellcom.co.il/.

Roger: Also, as is always the case with Big Yield Hunting, no one should overload on Cellcom, and no one should invest without full recognition that this is an aggressive investment. Volume on the NYSE appears to be decent on a daily basis, but don’t chase this above our buy target of USD32.50

We’ve seen a couple of Big Yield Hunting recommendations really blast off following our writeups, some well above our target entry points. If that happens with this one, investors are definitely better off being patient. There’s always another train leaving the station and a stock that goes up purely on our recommendation will almost certainly come back to earth eventually, giving everyone another chance to buy at a good price.

David: That’s always good and welcome advice. This month’s prey is settled: Buy Cellcom Israel Ltd up to USD32.50 on the New York Stock Exchange.

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