Description

Megacable (Mega) was written up nearly two years ago by Par03, and this write-up is worth a read for more background information.  Several Mexican companies have sold off on AMLO/Peso related concerns.  We originally looked at Televisa (TV) and shares undoubtedly look inexpensive relative to its asset base.   While TV has attractive cable assets, investors also must endure substantial satellite and content exposure.  And this led us to Megacable. While the drop in Megacable has been less severe than other Mexican names, this decline has nevertheless made shares very attractive relative to Megacable’s growth rate and takeover potential.  

Consistent Execution/Further Growth 

At the highest level, we think Mega shares (at roughly ~6.3x 2020 EBITDA) look attractive relative to the company’s pristine (albeit inefficient) balance sheet, consistent execution and our double-digit projected EBITDA growth from 2018-2020.  

    Unless otherwise noted, all figures in Mexico Pesos throughout write-up

Mega should benefit from increases in broadband penetration rates as well as continued growth of its fiber network.  Broadband penetration rates are roughly 65 percent within Mega’s footprint (some sell-side reports have pegged the number closer to 50 percent – the 65 percent estimate comes from the company), with the Megacable estimating penetration rates expanding to 74 percent over the next 5 years.  Mega has generally been expanding the numbers of homes passed by (4-5%) over the past 3-4 years using the existing city fiber rings within its footprint as well as additions to towns less than 10 kilometers from existing towns. At a cost of ~$10 (US) node to home and roughly $80 (US) in total subscriber acquisition costs (including CPE/Labor/promotion/ etc.), Mega generally recovers costs quickly at ARPUs of ~$20 (US), generating attractive IRRs.  Returns drop off if the new passings are outside the immediate city covered but, again, Mega is only expanding ~10 kilometers from existing cities, not laying fiber for completely new cities.

Network investments, continued home passings and further corporate segment investments (discussed later) have driven capex levels to ~30 percent of revenue versus levels ~20 percent 5-6 years ago.  Network investments should level off in the next 2 years and capex spend levels should decline. While Mega likely could take capex spend below 20 percent, this would likely correspond to fewer home passings and less enterprise growth.  It is more likely that capex levels will fall to something closer to 24 percent on a revenue base driven by ~4% ARPU increases, which are in-line with recent inflation levels.  

Undoubtedly, some of TV/Mega success can be attributed to the company’s ability to bundle Broadband/TV/Phone, as RGU’s per sub have steadily increased over the past several years.  Mega targets a 2.5x RGU/Customer ratio over the medium term. This bundling combined with price increases and value-added product up-sales (Xview – essentially Mega’s version of Xfinity -  and high definition packages) have allowed the recent 3-4% ARPU increases. 

Telecom regulation currently prevents incumbent América Móvil (AM) - with roughly 36% penetration rates inside Mega’s footprint -  from owning a TV license. It is believed that this restriction will be lifted sometime in 2020, although it is possible this could occur later this year.  With a TV license, AM could bundle services but would still have difficulty competing given the speed disadvantage of AM’s copper footprint. Roughly 70% of AM’s broadband subscribers are on DSL networks versus 30% with fiber connections.  Fiber connections are generally concentrated in more urban areas, and Mega does not have a residential presence in Mexico City/Monterrey where AM’s fiber presence is higher. Assuming AM receives the TV license, it will undoubtedly lay additional fiber, including within Mega’s footprint.  That said, current regulation forces the company to open its pipes to competitors and this regulatory burden will likely limit the extent of the fiber rollout. Mega indicated that TV recently requested access to a portion of AM’s network with a not-so-subtle warning to AM that fiber rollouts will likely create other wholesale offerings.  Certainly, there is risk to Mega’s story should AM receive a TV license sooner than anticipated and/or decide to rollout fiber more aggressively than anticipated despite the wholesaling risk. Additionally, Mega does face some upstart competition from Grupo Salinas’ Totalplay package. While its penetration rate (~5 percent) is small, it could negatively impact future growth.  While Mega believes the company is unaffected or could conceivably benefit from further telecom regulation, regulatory winds could change in unexpected ways, particularly if open access rules were ever to find their way beyond the preponderant carrier.  

Corporate Segment Growth to Continue

Mega’s topline revenue has benefited from a robust commercial offering, which currently accounts for 18 percent of revenue, with the largest sub-segment roughly tripling revenue over the past 3 years.    The segment offers broadband/telephone access products while also upselling existing businesses with higher value-add IT offerings (network/cloud services, equipment sales). Mega has been expanding its corporate offering into locations outside its core footprint (offnet cities), including recent expansions into Mexico City, Monterrey, Cancún Juárez and Mérida.  Mega sees continued strong demand for its enterprise offerings and also sees additional opportunities to expand into other offnet cities. Furthermore, Mega would be interested in pursuing further acquisitions within the corporate segment. 

We are generally above consensus estimates for EBITDA growth over the coming 2-3 years.  First quarter KPI trends were admittedly weaker, with Mega citing some economic concerns impacting churn/take-up rates.  Mega claims it made a strategic decision to target higher value-add subscribers and that it expects trends to improve the remainder of 2019, driving double digit EBITDA expansion.  Margins will see some pressure from Mega’s MVNO offering with Red Compartida (Red). Similar to the CMCSA/CHTR stories in the US, the MVNO will weigh on margins early, but Mega believes the offering will be profitable on a standalone basis and will further benefit the core cable business as churn levels decline.  Mega has noted that the wholesale offering from Red is superior to a past structure with Telefonica, which competed with Mega mobile offerings and (according to Mega) would simply copy whatever mobile offering Mega proposed prior to Mega’s launch.   

Poison Pill/Takeout Candidate

Historically, Mega has traded for anywhere from 8-10x EBITDA and therefore multiple expansion would appear very possible from current levels.   Even at the lower end of this range, investors could likely achieve attractive IRRs despite the less efficient capital structure, and this structure could change in the coming year.  Mega has a stated policy of paying out 20% of EBITDA as a dividend although the actual payout ratio has been higher depending on the year. While buybacks would appear to be far more value enhancing at current levels, they do not seem to be a priority for the company/family.   

And of course, a takeout is possible.  TV has publicly expressed an interest in acquiring Megacable.  We also believe other suitors – including Liberty Latin America who likely desires a possible Mexican entry– could be interested in Megacable given its consistent execution and further growth potential.  While Mega is already the second largest cable company in Mexico, it could benefit from additional scale in its capex and programming spend. Mega has a poison pill which requires a suiter to pay at least a 20% premium to the stock’s trailing 52 week high, implying a current takeout price of ~$120.  As of now, there are no indications that the Bours and Mazon families are interested in selling shares, but certainly a takeout seems logical over the medium term.  

Risks Appear Priced into Current Valuation

So, what could go wrong?  As previously noted, regulation changes are always a concern for cable investors.  While Megacable does not seem to be a primary target, this could change over time. Additionally, FX exposure could negatively impact margins and cash flow.  Roughly 90-95% of Mega’s total content costs and ~85% of its capex spend is dollar denominated. Content contracts offer some protections (different costs/sub at weaker F/X levels) as does the company’s more defensive balance sheet.  But, a sharp deterioration of the peso from current levels would negatively impact operating results as well as investor sentiment towards Mexico. As previously noted, Mega will likely faced some increase in fiber competition. While the company believes this risk is priced into its low double-digit medium-term forecast, it is possible that competition is more severe than anticipated.  Finally, it is possible that Megacable’s families decide against selling and instead pursues further acquisitions, subjecting shareholders to capital allocation risk.  

The above factors are real but appear mitigated by the company’s consistent execution as well as its current valuation.  If there is no takeout, Mega shareholders could still do well simply from further broadband penetration growth, continued enterprise expansion and ultimately higher free cash flow dropdown.  Certainly, further AMLO noise/trade worries could negatively impact shares, but if we are directionally close on the growth opportunity, it is difficult to see Mega’s multiple falling meaningfully from current levels and therefore downside appears limited.  Mega has traded at a premium to US cable names in the past, and while a complete reversal may not be imminent, it is possible that the gap should materially narrow should emerging market sentiment improve. And of course, the strategic value of Mega’s pipes should continue to grow over time, making further acquisition rumors a near certainty.    

Catalyst

-Acquisition target

-Continued double-digit EBITDA growth

-Increase in net leverage target