Magyar Telekom

Magyar Telekom (MTEL) is the principal provider of telecom services in Hungary, Macedonia, and Montenegro. Company provides a broad range of services including traditional fixed line and mobile telephony, data transmission, and telecom consulting. It is 59% owned by Deutsche Telekom. MTEL generates consistently high Returns on Invested Capital (25-30%) and stable EBITDA margins (38-41%) which are both signs of great business with high barriers to entry. It is trading at low multiples (2.9x '08 EV/EBITDA, 6x '08 P/E), multiples that usually reflect a rapidly declining business.The best thing about those earnings is that they are pretty much guaranteed to be fully paid out every year to company’s shareholders. The dividend that is coming up in April represents a 13% yield on current price. Future dividends should be even higher since the company is now at a lower bound of its target of 30-40% net debt/equity ratio and its cash generation is well in excess of net profit. Just as an example if 2009 profitability for the company is 23% down, the dividend should still be 16% higher in order to remain on the lower bound of this 30% net debt/equity ratio. I estimate that current purchase price for the company can be paid back within six year from dividends alone.
At the same time a lot of Eastern European fixed line telecoms are trading at low EV/EBITDA ratios and high dividend yields. Besides Hungarian Telecom this includes Lithuanian telecom, Estonian Telecom, and others. The main reason why these companies are so cheap is the fact that their subscriber numbers, and subsequently revenues, have been going down dramatically. They are being treated by the market as dying businesses without possibility of increasing revenues.
In addition to general fixed line telecom issues, Hungarian Telecom’s market perception is further amplified by an especially poor macro situation in Hungary. Hungary is one of the two Eastern European countries that had to be bailed out by IMF and it currency is down 35% against the dollar. As will be explained further, this fear is overblown creating attractive investment opportunity.
Unlike many other Eastern European countries that grew in double digits in 2006-2007, Hungary’s growth has been held back by their effort to reign in excessive government spending and budget deficit. As a result they had to take their hard medicine early on in the process in an environment that is slightly more forgiving than current situation. The latest IMF bailout put in strict controls on the country and is allowing the politicians to take the steps necessary to fix countries problems and prepare it for the next upturn. 2008 results for Hungarian Telecom and other companies in the sector suggest that economic downturn has little effect on people’s spending on telecommunications. The decline in country’s currency has no effect on company’s business since both revenues and costs are priced in Hungarian Forint. It is true that their dollar revenues are smaller as a result but the recent 35% decline should account for most of the eventual drop in the exchange rate.
To address the declining business concern, I believe that fears of the impending demise are overblown for fixed line telecom segment in general and Hungarian telecom in particular. It is a fact that these companies have been losing revenues and customers for the last five years. What market does not realize is that fixed line penetration decline has slowed down dramatically and voice revenues are being substituted by data revenues, from DSL and other services, at an increasing pace. Fixed to mobile substitution process is nearly complete as mobile penetration in most Eastern European countries has exceeded 100%. These investments are especially attractive, since the profits in the incumbent fixed line telecoms are usually protected by unassailable barriers to entry created during the period of infrastructure development under monopolistic conditions.
In the case of Hungarian Telecom fixed line penetration in its core market fell from 37% in 2003 to 26.9% in 2008. At the same time the rate of decline is going down from 5.4% in 2007 to 1.9% in 2008. Hungarian mobile penetration now stands at 122% and most customers who wanted to switch to mobile only service have already done so. Hungarian Telecom is also working hard on retaining the remaining customers by signing them up to service packaged that include TV, Voice and Internet offerings. Currently 40% of the remaining fixed line customers purchase more than one service from M-TEL.
The effect of company’s efforts is starting to take hold. In the last two years number of fixed line customers fell by 23%. At the same time fixed line revenues fell only 11% and EBITDA stayed approximately flat since company is able to get more revenues from each customer. Data revenues (internet and IPTV offering) have grown 10% and it is evident from operating margins that these revenues are just as profitable as existing voice business. Hungarian fast internet penetration stands at about 2/3 of western European levels and still has plenty of room for growth. While voice revenues are likely to fall further, but growth in data revenues is likely to reverse fixed line sales decline within next few years.
The beauty of Hungarian Telecom is that fixed line is only a part of their business. They also own largest mobile operator in Hungary, Macedonia and Montenegro. This business is growing, generates more revenues than fixed line (351B HUF vs. 290B HUF in 2008), and has higher EBITDA margins. In addition to that Hungarian Telecom controls second biggest cable operator in Hungary and a rapidly growing IT systems integrator. This range of services and their market share gives Hungarian Telecom confidence that even if a customer decides to leave their fixed line offering, there is more than 50% chance they will end up using one of their other services anyway.

Competitive Dynamics: Hungarian Telekom is a fixed line incumbent in Hungary and as is often the case with such companies enjoys dominant market share in fixed line communication - 77%. It also owns T-mobile Hungary which is the largest of the 3 mobile operators in the country with 44.5% market share. Its strong position extends to internet services as well where more than 50% of the market is served by MTEL either directly or through ISPs which use MTEL's backbone. Company is so powerful that Hungarian authorities had to take steps to increase competition in mobile segment. They have set interconnect charges in a way that would penalize MTEL and benefit other two operators. This regime has been in place for the last few years and was finally eliminated in 2008.

Valuation: I have already mentioned the high dividend payment and the value associated with it. Taking into account the dividend payments and a slight expansion of multiples to 4.5x EV/EBITDA an investment in Hungarian Telekom should generate IRR of over 30% on current price. Current market penalizes all stocks with any perception of risk. Hungarian Telekom is suffering from Hungarian macro and fear of declining revenues. As have been explained above I believe neither one of these things are justified which creates a very attractive investment opportunity.