Value Investors Club / NOS (NOS PL)

Description

April 2016

Market cap.: c. €3.0bn / EV: c. €4.4bn / ADTV: c. €5 to 6m

As always, we’d love to hear anyone’s thoughts in the comments section. Good, bad, indifferent. Thanks in advance for taking the time to read the write-up.

1. Summary of the investment case:

a. NOS is a domestic cable operator in Portugal. The Portuguese market has been swiftly moving towards a converged product (e.g. broadband, TV, mobile, voice, etc.) and NOS is well positioned to capitalise on this secular trend: the company has been taking share from competitors, has a high quality and price-competitive offering, and scores highly on many consumer surveys.

b. The company has been somewhat of a darling of investors (mainly institutional asset managers, but also many U.S. East Coast-based “fundamental” hedge funds, etc.) but the share price has stumbled of late, down c. 20% since December 2015 to c. €6.1 per share.

c. We believe the cause of the recent share price decline is temporary and largely non-fundamental in nature.

i. The company recently surprised the market by stepping up its FTTH roll-out plans, which cuts investors’ near-term FCF estimates by c. 20%. The choice of a step-up in discretionary growth capex is driven by NOS having met with good success (i.e. high RONIC) on its recent FTTH expansion, and is likely to be decently NPV positive over the mid-to long-term.

ii. Unfortunately, the company poorly communicated the NPV positive nature of the capex increase on the last conference call. The capex increase and poor communication re. its merits spooked investors with a shorter-term investment horizon and/or momentum bias. Having spoken with the company at length in recent months, we believe management recognises its communication errors and will do a much better job at the forthcoming results (and the subsequent investor roadshow) at and publicising the positives re. the growth capex plan.

iii. The company is also locking horns with Portugal Telecom ("PT") over Liga rights, which has NOS investors worried. Having spoken at length to all parties, it feels to us that none of the competing parties wants to be the aggressor and all parties are seeking a relatively amicable solution that avoids using Liga rights as a source of competitive leverage. This stands in stark contrast to most investors’ assessments of the topic. Our discussions give us confidence that the matter should be resolved in a way that doesn’t reduce NOS’ mid-term earnings power, which should lead to this investor sentiment overhang disappearing over the next quarter or two.

d. These temporary and largely non-fundamental reasons that have caused Mr Market to misprice NOS provide an interesting entry point for an investment in a company that we believe to be well run and that we conservatively think can grow revenues at c. 5% p.a. to 2020E, EBITDA by c. 7% and Op. FCF or uFCF at > c. 25% p.a. over the same period. A variety of valuation methodologies (we prefer FCF yield) gets us to a fair per share value in 2018E is c. €10.5. This implies a N3Y potential IRR of c. 20% in our ‘base case’, which we believe is an attractive annualised potential given the relatively limited risk profile of NOS’ business.

2. Business overview

a. NOS is a domestic cable operator in Portugal, and was formed from the merger of ZON and Optimus in 2013.

b. Cable operators in Europe, notably Telenet, have seen success in cross-selling mobile products into their fixed bases and we see scope for NOS to continue gaining mobile share in a similar vein.

c. NOS competes primarily against PT and Vodafone ("VOD"). Cabovisao is a minor cable competitor (spun-out of PT) that was purchased by Apax France (a PE firm) in 2015.

i. NOS has c. 36% share of the broadband market (vs. VOD at c. 13% and PT at c. 46%)

ii. NOS has c. 44% share of the Pay TV market (vs. VOD at c. 13% and PT at c. 43%)

iii. NOS has c. 26% share of the mobile market (vs. VOD at c. 33% and PT at c. 41%)

d. The Portuguese market has been swiftly moving towards a converged product offering (e.g. broadband, TV, mobile, voice, etc.), with all competitors (irrespective of their initial origin, e.g. VOD and mobile, NOS and Pay TV, PT and broadband/fixed line voice, etc.) moving towards converged products in recent years. The focus on converged products has led to lower customer churn, though led to a very competitive period from 2011-14A as VOD aggressively expanded its broadband and Pay TV offering to protect its mobile-only back-book from share loss.

e. For more details, please do consult the IR materials and/or sell-side reports (Morgan Stanley, Berenberg and CS provide decent coverage).

3. Growth potential

a. We believe NOS should be able to grow Group revenue by c. 5% CAGR to 2020E, based on the following key drivers:

i. Consumer segment: NOS is building out the last few hundred thousand homes in its FTTH footprint, which should get NOS to c. 100% fibre/cable coverage of the Portuguese household market (c. 4.0 to 4.1m homes).

1. In recent years, NOS has been taking share from competitors (PT and VOD) in the converged product market (which we think is the most illustrative measure of competitive strength in Portugal, rather than product-specific share info., given the converged nature of the market and the broader trends in this direction.)

2. We believe that NOS should be able to get to c. 34 to 35% market share over the mid-term (which implies c. 1% of share gain, which would be conservative vs. the last few years), given the company’s high quality offering (demonstrated by its high net promoter score, leading set-top box technology, etc.).

3. We see evidence to suggest the company could end up with more like c. 36 to 38% market share on a three to five year view but, given that is a fairly speculative view, we chose to assume c. 35% share through to 2021E

ii. Consumer segment: NOS increasing its penetration of mobile subscriptions in its fixed line customer base.

A. NOS currently under-indexes vs. VOD and PT on penetration of the mobile market, given its heritage as a cable operator. NOS currently has c. 26% of the mobile market, vs. 44% of TV and c. 36% in broadband. (VOD has historically been mobile-only and moved into fixed and TV in recent years, whilst PT has always offered mobile and fixed products).

B. NOS has been taking share in mobile in recent years. The company’s offering is of similar quality and price to VOD and PT, so there is good grounds for believing NOS should continue to be able to take share in mobile and reach a penetration level in line with its broadband/TV market share

iii. Consumer segment: Blended Retail ARPU growth of c. 2% CAGR to 2020E in fixed and mobile is feasible.

1. This c. 2% in ARPU growth across the subscriber base factors in continued mix-shift as NOS (and PT and VOD) up-sell customers onto more converged products.

2. Whilst we note that NOS’ penetration of 3P/4P is already relatively high at c. 80% of the subscriber base (we think 4P penetration is more like c. 50%), there is certainly some further mix-shift or up-selling benefits to be had from here over the next few years.

3. As such, we think that our estimated c. 2% ARPU growth factors in very little benefit from market-level price rises that could result from increasing cooperative behaviour by NOS, PT and VOD, which we are increasingly positive on (having come from an initially sceptical position). As such, we believe our pricing estimates are decently conservative, with scope for faster price rises than c. 2% p.a.

4. For context, 2015A delivered c. 3 to 4%, with more evidence of cooperative behaviour from PT and VOD.

iv.Business segment: Growth in Commercial/Enterprise revenue of c. 4% CAGR to 2020E

1. NOS has been taking significant share from PT (the incumbent with majority market share in Commercial/Enterprise). NOS only has a small back-book of customers and the incremental returns from undercutting PT’s pricing by c. 15 to 20% are attractive for NOS vs. NOS’ Group margins; the company has been taking share from PT in 2015A.

2. PT has been responding by cutting prices, too, but we believe there is still a good deal of low-hanging fruit for NOS to pursue over the coming years to justify c. 4% revenue growth in this segment from share gain.

3. Given the low ARPU of the Commercial back-book, there is scope for NOS to raise prises (something PT is probably willing to go along with, given its falling top-line and high leverage).

4. We believe this aspect of NOS’ growth is quite under-appreciated by the market. What is interesting is that many of the enterprise contracts won by NOS took place in 2H 2015A. It takes some time for enterprise customers to transition, which means we may see a small unexpected boost to revenues in 1H 2016E.

i. In support of the above estimates, we note that historical group-level revenue trends have been strong:

1. 4.4% revenue growth in FY 2015A; 6.5% in Q4 2015A

2. 4.4% EBITDA growth in FY 2015A; 8.6% in Q4 2015A

3. Q4 2015A delivered 13% y-o-y RGU growth

4. Business quality assessment

a. Competitive intensity: our base case is predicated on competition from VOD and PT remaining as is; competitive but manageable.

ii. In theory, a three-player market where each competitor has similar market share is very well suited for cooperative/oligopolistic behaviour, though we reiterate our point that telecoms operators have historically failed to take advantage of such cosy market structures. (Perhaps Portugal over the next few years will prove different.)

i. There are actually indications suggesting that competitive intensity could be declining, with all operators putting through big price rises in 2015A (c. 2 to 5%), so there is potential for cooperative behaviour to improve further.

ii. Having spoken with both VOD and Altice (owners of PT) recently, it feels as if both competitors are much more willing than they used to be to pursue a strategy of gently reflating pricing across the market. (We are cautious on this front. In our experience, telecoms investment theses that are based on competitive intensity receding are numerous, but with paltry few successes. Telecoms operators are too prone to compete, unfortunately. It’s a risk we are monitoring closely.)

iii. With VOD and PT both setting aggressive targets for FTTH coverage over the next few years (PT aim to cover the entire country with fibre, in a similar fashion to NOS), we were initially concerned re. the over-build risk (the combination of sunk costs / high fixed costs and potentially aggressive competitors was an immediate red flag re. potentially low ROIC for all competitors on a mid- to long-term basis.)

iv. After further (rigorous) analysis, we have gotten comfortable that NOS’ subscriber base is not at major risk of share loss from overbuilding by PT and VOD. If anything, we think NOS can take share from others.

v. NOS only has c. 1/3 of the fixed line market share, so is not “dominant” and therefore exposed to risk of subscriber loss if market share was to normalise to a more equitable split between three equally competitive companies (e.g. a risk that Cablevision may have with FiOS in the U.S.). Furthermore, a significant amount of NOS’ subscriber base has been already overbuilt with fibre by both PT and VOD (we estimate c. 75%, based on discussions with industry participants) for some time. This suggests that if NOS was likely to lose share to PT and VOD, it would already be happening. We have not found any evidence to suggest this is happening.

b. Negotiations around the Liga football rights (the Portuguese football league), which are ongoing, are a key upcoming indicator of PT's willingness to 'fight' vs. pursuing a more cooperative agenda. Investors are firmly focused on this issue.

i. Historically, Liga football rights (a fairly important product for the few hundred thousand, high ARPU football-mad viewers) were distributed via a wholesale agreement and every TV provider showed them; they were not used as a competitive bargaining tool and competitive cooperation was high.

ii. Sometime after Altice acquired PT, a mad dash by both NOS and PT to secure exclusive rights to Liga content occurred. Interestingly, both PT and NOS suggest the other party was the cause of the rush; NOS intimate to investors that they would gladly go back to the wholesaling arrangement. Altice suggest similarly. This implies scope for an agreement, in our view. Investors are more concerned.

iii. It is a key risk factor to monitor, but we see a path to agreement that doesn’t impact NOS’ earnings power.

iv. For what it’s worth, our detailed analysis has led us to believe NOS is better positioned to benefit over a one to three year period if NOS and PT cannot reach a wholesale agreement. (That said, this scenario would slightly and negatively impact NOS’ near-term FCF, and would likely prompt further investor sentiment weakness).

c. Regulation (a key risk factor for any telecoms investment) in Portugal is placid.

d. Thinking about the relatively competitive strength of NOS, PT and VOD, our view is that none of the three companies has a significant consumer- or production-related competitive advantage over the others.

i. PT and VOD benefit from the deep pockets of Altice and VOD group, respectively, but Altice is very focused on improving PT’s (poor) FCF generation and Patrick Drahi is not known for wasting money.

ii. If anything, we think that NOS is the strongest competitor of the three (we would say that though, wouldn’t we). NOS’ record of subscriber growth in recent years, taking share from PT and VOD, is indicative of NOS' strong brand, high customer satisfaction and leading technology. Our checks on the ground support this view.

e. Economics and profitability: our base cases suggests scope for EBITDA growth of c. 7% p.a. to 2020E, benefiting from the last round of synergy realisation (from the Zon/Sonaecom merger from a few years ago, out of which NOS was formed) and a small amount of operating leverage.

f. This takes EBITDA margins from c. 37% in 2015A to management's mid-term target of c. 40%.

i. We think there is good scope for mgmt. guidance to be raised over the N12M (management guidance comes from a CMD from almost two years ago), so these estimates may prove conservative. Clearly, any increase in mid-term margin guidance would be well-received by the market, though this is not our base case. For context, PT’s EBITDA margins are c. 41%, with Altice confident of raising them further over the next two years.

iii. There are c. €25m of remaining synergies to be realised from the Zon/Optimus merger, which should be back-end loaded into 2017E. We assume these are unlikely to help 2016E. For reference, these remaining synergies to be realised are c. 30% of the original synergy plan target of c. €80 to 90m. Management have confirmed the synergy plan remains firmly on course.

ii. Every percentage point in market penetration in Retail BB that NOS gains/(loses) by 2021E vs. our base case of c. 35% adds c. €0.2 per share in value (based on a DCF analysis). It’s not infeasible for the range to be c. 32 to 38% by 2021E, theoretically swinging fair value by c. +/- €0.6 per share

iii. Every percentage point in ARPU growth in Retail that NOS gains/(loses), vs. our base case of c. 2% p.a. on a normalised basis adds c. €0.4 per share in value (based on a DCF analysis)

g. Leverage: in our view, gearing is ‘prudent’ (not too high, not too low) at c. 2.1x ND/EBITDA for a cable/telecoms company, given the business’ stability. Excess cash generated, beyond organic investment requirements, will likely be returned to shareholders via dividends, with leverage kept at c. 2x ND/EBITDA (a mid-term payout ratio greater than c. 150% of NI or eFCF is therefore feasible, or SBBs, or both).

i. We think the sell-side estimates (grossly) underestimate the cash-return optionality to the NOS investment case, which leads to mid-term EPS and eFCF per share forecasts that do not properly reflect management’s leverage targets. This is one of the reasons we think the market is under-estimating NOS’ mid-terms compounding potential.

ii. Though we believe it's unlikely to materialise, there's probably scope for the B/S to be geared up to c. 3x and another c. 25% of the market cap. returned to shareholders.

iii. NOS recently issued new debt to bring its blended borrowing rate to c. 2.5%, only just above government rates. This is indicative of debt investors' appreciation for NOS' low risk business model (a view that indicates, to us, that NOS is likely to be seen as fairly 'defensive' in a risk-off environment vs. other Portuguese securities).

iv. We have capitalised our estimate of long-term spectrum renewal costs and added them to net debt (what we call "economic net debt"). Details are in the financials at the end of the write-up.

h. Capital allocation / intensity: As noted in the introduction, NOS recently said that capital intensity will be elevated and prolonged vs. the market's expectations going into Q4 2015A results. NOS is increasing its success-based growth capex plans through 2017E. This is a result of recent high RONIC successes where the company has gained significantly more market share, in a shorter time than expected, after recent FTTH expansion.

i. These growth capital investments are likely to be NPV positive and we think eminently sensible, though they have hurt the market's near-term FCF forecasts. The benefits of the change in capex plans were poorly communicated to the market, spooking investors, and we think most investors and sell-side analysts have temporarily misunderstood the positive revenue growth implications of this capex step-up.

ii. As capex intensity declines and operating margins expand, NOS' uFCF margin should expand from c. 10 to 16% by 2020E. This should drive a mid-term, post-tax ROIC of c. 15%, which is decent-to-good for a cable/telecoms company.

5. Management quality assessment

a. Mgmt. have been very competent at capital allocation and operational stewardship since the Zon/Optimus merger in 2013, with long records in the industry. We think they are a good team for us to be trusting with our investors' money. Mgmt. incentives are linked to mid-term FCF and EBITDA growth targets and vest over three to five years, which we like.

b. That said, mgmt. own very little equity, have fairly small stock-related LTIP plans, and the board of directors looks totally non-independent. NOS' majority shareholder (more than 50% ownership) is Sonaecom and Isabel Dos Santos; they effectively control the board of directors.

c. Whilst the mgmt. and board of directors have done nothing to suggest they shouldn't be trusted, and we've seen no evidence of prejudice of minority interests in favour of the interests of majority shareholders, the potential conflict of interest is obvious. From our interviews of sell-side analysts, we think the market is very sanguine re. this potential risk to minorities. We are more cautious, though believe the risk is sufficiently small not to outweigh the potential upside. Clearly, it needs to be monitored closely.

6. So why is NOS mispriced? What could cause the share price to re-rate?

a. NOS' strong operational performance through 2014-15A likely promoted a sense of complacency amongst NOS shareholders. Many investors probably saw NOS as a stable ‘deliver and beat’ growth story, which it very much has been, given its strong operational performance.

b. But after such smooth sailing, recent question marks re. (a) the Liga football rights situation, and (b) the poor way in which the growth capex step-up was communicated - with little explanation of the benefits - have spooked investors, some of which were probably quite focused on share price momentum, given NOS' strong run through 2014-15A.

c. We think these issues are likely to be speed bumps, rather than risks of permanent impairment of capital. We believe there is a good chance that 'normal service’ should resume in investors’ minds over the next few quarters.

d. We think that many investors have been too short-sighted re. appreciating the value uplift from the growth capex step up, with N2Y Op. FCF estimates likely to be cut by c. 15 to 20%, roughly in line with the share price decline of c. 25%.

i. Given the NPV positive nature of the investments, we think this is an over-reaction from Mr Market.

ii. The sell-side is also guilty here of raising capex estimates but not raising revenue estimates. A few have started to “get it” (as a result of having had follow up calls with management over the last month or so), but NOS’ small market cap. means it is far from the most important company in any sell-side analysts’ coverage universe, so they are in no real rush to update their analysis and/or forecasts. We believe this will happen over the coming months.

e. Management realise they have made a (rare) communication error with the market. There is good reason to believe, at the next earnings update, they will ram home the benefits of NOS' strategy, which should re-excite investors.

f. The growth opportunity in Corporate is also probably under-appreciated by the market. NOS has been doing well re. new contract wins, taking share from PT, as discussed above.

i. What's particularly interesting is that there is a lag between winning large corporate contracts and customers transferring, due to the complexity of large corporate customers' needs.

ii. A very strong 2015A for contract wins should actually filter into 2016E revenue growth, which we think might positively surprise investors. In simple terms, there looks scope for NOS to 'beat' on quarterly earnings.

g. NOS reports Q1 2016 earnings tomorrow. We believe there is decent scope for mgmt. to be more positive re. the growth capex plans (though we are probably setting ourselves up for a fall, posting the idea so close to earnings…! We’d suggest waiting to see how earnings come out before sharpening your pencils).

7. Margin of safety and potential returns

a. NOS looks attractively valued given its c. 5% mid-term revenue CAGR, c. 7% EBITDA CAGR, and > c. 25% uFCF CAGR (which is flattered by capex declining from temporarily elevated levels in 2014-16E, as the FTTH growth capex ceases).

b. If we assume revenue normalises to a c. 2% p.a. long-term growth rate and that drops down to mid-single digit EPS growth, we believe a fair eFCF multiple is c. 14 or 15x.

c. Applied to 2019E eFCF, that implies a fair share price in 2018E of c. €8.5 to 9.0. Add in c. €1.0 in cumm. dividends and SBBs (to maintain leverage of c. 2x ND/EBITDA) over that period and fair value per share in 2018E is c. €10.5.

d. This implies a N3Y potential IRR of c. 20%, which we believe is attractive given the risk profile of the business.

e. uFCF, EBITDA, P/E and Op. FCF multiples all support these IRR estimates (most imply slightly higher IRRs of c. 20 to 25%, in fact), as do peers’ trading valuation multiples, NOS' historical valuation multiples, and a DCF analysis.

f. Strong mid-term revenue and FCF growth, which has multiple drivers (i.e. is fairly resilient), means that we think we can argue that intrinsic value is increasing at somewhere between high single digits p.a. (in line w/ EBITDA growth) and low teens (with one eye on > 30% uFCF growth) on a mid-term basis (i.e. one to five years). This means that time should be our friend, even if the catalysts don’t eradicate the market’s mispricing of NOS’ shares in the short-term.

8. Risk summary:

a. Potential for competitive intensity to increase: this is always a major risk for telecoms/cable companies. In Portugal, PT + VOD have matched NOS’ willingness to put through price rises, which is positive. This needs to be monitored carefully.

b. Liga rights: PT has shown some aggression re. its approach to Liga rights, but appears to have backed itself into a corner. If this episode is not resolved amicably (wholesaling of all football rights across all providers, as per the status quo), it could (a) hurt NOS investor sentiment, and (b) hit NOS’ earnings in the short term (though could be beneficial in the mid- term).

c. Misalignment of incentives between majority and minority shareholders, or negative news flow related to majority shareholders, could hurt the share price, though we see little tangible evidence of this being likely in the near- to mid- term.

d. Portuguse macro, which could/would impact consumer confidence (and investor sentiment, e.g. the fair multiple).

9. Key drivers of the investment thesis that we think are important to monitor to see if it is ‘tracking’ to plan:

i. Network expansion plans (HP) for NOS, PT and VOD remaining on-track w/ guidance (fine ATM).

ii. NOS meeting penetration target of c. 25% of new HP in mid-term + c. 35% in aggregate (tracking well ATM).

iii. Competitive intensity lessening + cooperative behaviour improving from PT and VOD (tracking well ATM).

iii. 1. PT, VOD and NPT aggression re. Liga rights potential issue (TBC – let’s see what happens). 2. NOS’ expanding Retail FTTH footprint might be met tit-for-tat by PT via Liga rights? (to be monitored).

iv. Capex normalising to c. 16% of revenue in steady-state (TBC; trust in mgmt. required but justified to date by their actions).

v. Continued opex control + synergy delivery towards c. 40% EBITDA margin target (tracking well ATM).

vi. Corporate revenue growth from share gain (tracking well ATM, though growth rate may slow into 2016/17E).

vii. Regulatory regime remaining placid (tracking well ATM).

viii. A ‘nice to have’ is also investor sentiment reflecting positively (i.e. multiple expansion)

10. Forecasts / fair multiples:

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Please see section 6 in main write-up.

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			2016	2017
Price:	6.10	EPS	0.29	0.38
Shares Out. (in M):	515	P/E	21	16
Market Cap (in $M):	3,050	P/FCF	22	17
Net Debt (in $M):	1,350	EBIT	225	274
TEV (in $M):	4,400	TEV/EBIT	19	16