Description

TMX ($19.38) Telmex ($ in millions except per share amounts)

The great majority of fixed-line telecom operators around the world are loosing business. With the exception of a few fast growing countries, with very low tele-density, like China, most fixed-line operators show a continuous decrease of lines in service, i.e. a steady drop in business volume. Telmex is not loosing business. Telmex continues to add fixed lines, grow revenues, and generate large amounts of cash. This cash, for the most part, flows back to shareholders in the form of dividends and share repurchases, which over the last five years have reduced the total number of shares outstanding by approximately 25%.

Telmex is the dominant fixed-line telecom operator in Mexico. While it has recently expanded into other Latin American geographies (Brazil being the most relevant), it obtains the great majority of its revenues from Mexico. As of 2Q05, Telmex had 17.9 million lines in service and 1.9 million internet subscribers. As mentioned earlier, it continues to grow lines in service. More importantly, as with other fixed-line operators, adding broadband subscribers represent the main opportunity in the foreseeable future.

Telmex has an attractive valuation (both in absolute and relative terms), a key component of a value investment opportunity. Currently, EV is $28,205 ($19.38/shr X 1148 dil shrs + $5957 net debt). For $28,205 you buy a company that generates $14150 of revenue, $4175 of EBIT, $4710 of Ebitda-Capex, and $2705 of net income. The respective multiples are 2.0x, 6.8x, 6.0x, and 10.4x. These multiples are very attractive for a company of this size, profitability, and competitive position.

The most significant difference between Telmex and other fixed-line carriers is Telmex’s ability grow lines in service as opposed to, in the case of most carriers, minimizing the line reduction rate. In markets like the US or Canada, for example, it is increasingly common for individuals to discontinue their fixed-line service and replace it with mobile service and [cable] broadband. However, in Mexico, you would have a very difficult time finding individuals who have given up fixed-line service.

Pricing of telecom services makes it anti-economic to substitute fixed-line for mobile service. Unlimited service mobile plans are prohibitively expensive; all other mobile service plans also make it unaffordable to use a mobile phone instead of a fixed-line phone. The most affordable mobile plan costs a little more than US$20/month, whether prepaid or postpaid, and includes up to 200 minutes of air time (but on average around 100 minutes). By comparison, for the same amount, a fixed-line phone includes 100 calls with no time limit. Each additional fixed-line call is about US$0.13 with no time limit, whereas each additional mobile minute is no less than US$0.10 (on average around no less than US$0.15). In addition, calling-party-pays has further solidified fixed-line service. When calling a mobile from a fixed-line phone, the user pays US$0.25 per minute. As such, there is a very strong economic incentive to make calls using the fixed-line network end-to-end. Furthermore, long-distance calling from a mobile phone also results prohibitively expensive. Finally, demographic factors further support fixed-line service. For a household of four or five (the typical household size) it is completely anti-economical to replace fixed with mobile service.

The reason behind this pricing structure is that the market, for practical purposes, is a monopoly. The same man controls the dominant fixed-line and mobile carriers. Competition in fixed-line is incipient at best. On mobile it is docile. All operators are happy with prices that are a multiple of what you would find in any large country. And just in case you are thinking about VOIP telephony and cable, suffice to say that the same man has an important say about the strategy of the dominant cable network.

Is this the right time to buy TMX? Could now very much be the peak of the Mexican market? Aren’t you concerned with potential extraordinary volatility due to next year’s presidential election? Well, that is precisely how I found TMX. The Mexican market seemed a likely candidate to short. However, after digging into the numbers I found TMX acting as a potential value anchor. This brings us to the subject of relative valuation. The top ten components of the Mexican market account for 80% of its market cap, with TMX accounting for around 15% of the total. These companies grow at a little more than GDP. Thus, the wide valuation gap makes TMX a relative bargain:

EV/ltm
Ebit Ebitda Ebitda-Capex Net income Div yield
AMX 20.2 11.6 25.1 24.9 0.5%
FMX* 12.0 7.7 10.9 27.2 0.8%
TV 13.4 10.8 13.5 24.2 0.9%
CX 13.0 9.5 11.9 14.6 2.3%
TMX 6.8 4.4 6.0 10.4 3.6%

*FMX adjusted for economic ownership of KOF.

Allow me to venture, for a moment, outside of the traditional domain of value investing. Despite solid macroeconomic metrics for the country, the prudent investor would hedge currency and market exposure. Companies in the peer group have very much the same currency and market risk. As such, the valuation gap does not make sense in light of similar economic prospects. First, as mentioned, companies in the peer group grow (organically) at a little more than GDP. Even AMX, it can be argued, going forward will grow at similar levels in Mexico as its market becomes saturated. Second, TMX enjoys a particularly strong competitive position, even when compared to that of its peers. We could discuss one by one, but in all cases except TMX we would find at least one strong competitor. Third, none of these companies is a likely acquisition candidate (or similar situation) that would support a valuation premium. Consequently, a rational investor would use the same cost of capital and slightly different short-term growth assumptions to value these companies. As such, TMX’s large valuation gap would be, at a minimum, substantially reduced.

Catalyst

As the company continues to repurchase shares, to increase its dividend per share, and the business continues to perform solidly, the valuation differential disappears.