This Undervalued Telecom Finds Large Scale in Small Markets

We think Millicom International Cellular is an interesting company. It has tended to focus on smaller and more out-of-the way countries than its larger peers have. As investors' interest shifted to the countries Millicom operated in, the firm often sold and realized a solid return on its investment. However, it kept a core business in Central America that was overlooked by

In 2014 Millicom grew its revenue organically 9.4% year over year, and with the acquisition of cable operator UNE in Colombia in August, it essentially reached our estimate of $6.4 billion. The firm grew its wireless base 12.4% to 56.3 million and, importantly, grew data usage 37% in local currencies, which more than offset pricing declines in voice and texting. For wireless, we expect data to be the primary growth driver in Latin America, while subscriber additions will drive its African operations. However, we think even faster growth will be generated from its other services. Millicom's cable operations increased revenue by 15.3% in local currencies, and its network now passes 5.1 million homes with about 40% penetration. We think the firm will continue to expand the reach of its network and its penetration rate. Finally, the number of people using its mobile financial services (MFS) jumped 51% to 9.5 million. MFS have been very successful in many African countries, but Millicom is also having success in Latin America, where others have struggled. We think there is lots of opportunity for this service, as many people in the company's footprint have no banking relationship. The firm also did a nice job of controlling costs. Despite the acquisition of lower-margin UNE, Millicom generated an EBITDA margin of 32.8% versus our projection of 32.6%.

Solid Record in Latin America and Potential for Progress in Africa Millicom is the largest wireless operator in Guatemala, El Salvador, Honduras, Paraguay, and Chad, as well as the largest pay-television operator in Costa Rica. It is the second- or third-largest operator in the rest of the countries it operates in. Due to the smaller size of many of these countries, they have seen much lower competition. The lower competition and Millicom's early entrance have enabled it to generate excellent returns on capital in Latin America. While it is only the third-largest wireless operator in Colombia, its acquisition of UNE brings it close to Telefonica in total subscribers today. In several Latin countries it has been adding pay television, broadband, and financial services. We think this is a good strategy, as wireless services are nearing saturation and revenues are actually declining as new subscriber growth isn't sufficient to offset lower prices for voice and text messaging. However, data services are growing rapidly, which, when added to these new ventures, we believe represents significant growth opportunities.

In Africa, wireless penetration rates are much lower, providing the potential for meaningful new subscriber growth. However, competition has increased since Bharti Airtel acquired Zain in 2010. This has prevented Millicom from generating the high level of returns in Africa that it has posted in Latin America. That said, we still think there is ample opportunity for long-term revenue growth, margin expansion, and improved returns on capital in this region.

Our Fair Value Estimate Is $94 per Share Following full-year 2014 results, we maintained our fair value estimate of $94 per share. With the acquisition of UNE, we expect revenue growth of about 23% in 2014 and a further 15% in 2015. We then expect revenue growth to average a bit below 9% for the following three years. We anticipate significant subscriber growth in Africa with lower amounts in Latin America, which will be partially offset by reduced ARPUs. However, we also expect significant increases in data usage and growth in broadband, pay television, and financial services. We project the acquisition of UNE to pressure Millicom's EBITDA margin this year and next, but then margins to improve as cost-cutting occurs from integrating UNE into Colombia's existing assets and revenue growth outstrips cost increases. Despite our revenue and margin growth assumptions, we remain below the company's mid-range goal of delivering $9 billion in revenue and 35% EBITDA margins in 2017. While the company reports in dollars, the various operations have significant exposure to currency movements that could materially affect our estimates.

Large Scale in Small Markets Means a Narrow Moat for Millicom We think Millicom has a narrow economic moat due to cost advantages and efficient scale. While the firm isn't large on a global scale, it is large within most of the countries it operates in. Scale within a country is generally more important than global scale for controlling costs within that country. However, the lack of global scale does prevent the firm from having any buying power over its suppliers for handsets and equipment.

Additionally, due to the small size of most of the markets Millicom operates in, it would be very difficult for another operator to enter the market, build out a network, and be able to generate a decent profit. In Central America, the populations are roughly 6.0 million in El Salvador, 13.4 million in Guatemala, and 8.5 million in Honduras. In South America the populations are 10.1 million in Bolivia, 45.7 million in Colombia, and 6.8 million in Paraguay. It is no coincidence that in Colombia, the one large Latin American country that Millicom does operates in, it is only the third-largest wireless operator. Given Colombia's size, competitors America Movil and Telefonica found it worth spending time and capital to enter aggressively years ago. While the two other players compete with Millicom in most of the other countries, their entrance was much later, and Millicom has been able to exploit its first-mover advantage and remain the largest operator.

In Africa, Millicom operates in many of the larger countries such as the Democratic Republic of the Congo (population of 75.5 million), Tanzania (48.3 million), and Ghana (25.2 million). A few smaller, but notable, countries include Chad (11.2 million), Rwanda (12.0 million), and Senegal (13.3 million). Despite the relatively larger population size and lower penetration rates, which have encouraged more than three entrants in some of these countries, Millicom is either the number one or two operator in all but one (Ghana, where it is the third of six players). Longer-term, we expect some consolidation in these countries that have more than four operators, which should ultimately help the firm's returns.

Search for New CEO Underway We view Millicom's stewardship of shareholder capital as Standard. Investment firm AB Kinnevik owns about 38% of Millicom's stock and is involved with setting the firm's strategy. Kinnevik's chairman, Cristina Stenbeck, is also Millicom's chairman. Kinnevik also controls Tele2, the second-largest wireless operator in Sweden and several other countries. While the two firms are in different regions currently, the significant overlap between board members could create a conflict of interest. Hans-Holger Albrecht suddenly announced on Dec. 2, 2014, his intention to step down as president and CEO at year-end. CFO Tim Pennington has assumed the role of interim CEO while a search is undertaken for a successor. Pennington joined Millicom as CFO in June 2014. Previously he was CFO at Cable & Wireless Communications, Cable & Wireless PLC, and Hutchison Telecommunications International. Many of the firm's key employees have extensive telecom experience but haven't been with Millicom very long.

Generally, we are pleased with Millicom's investment decisions. The firm was an early entrant into most of its markets, which has helped provide a first-mover advantage in many cases. Management has also been willing to sell out of countries when it receives good offers. However, we think its current holdings will likely be maintained unless it receives a really outstanding offer.