Millicom Is Undervalued

We are encouraged by

The most important item, in our eyes, is the continued expansion of Millicom’s convergence program. On this front, the company is making steady progress. It expanded its cable footprint by passing a record 370,000 homes in the quarter and now passes 8.4 million in total. This increasing scale provides opportunities for future growth. Additionally, the firm continues to expand its 4G coverage. It added 400,000 4G customers in the quarter, taking its 4G subscriber base to 3.8 million. 4G customers tend to have average revenue per user levels that are more than twice those of other subscribers. As Millicom converts its wireless customer base to 4G, its ARPU should increase and add to revenue growth. Overall data usage increased about 20%, but this is being offset in most countries by continued declines in voice and SMS revenue. In Colombia and Bolivia, data revenue now exceeds voice and SMS revenue, and others are moving in this direction, which makes data growth increasingly meaningful.

Millicom continues to work on reducing costs; its EBITDA margin was 36.6% in the quarter, up 0.6% year over year and ahead of our full-year estimate of 36%. However, the first quarter generally has the highest margin of the year, so we still expect the full year to be near our projection.

Government changes hurt the quarter and will be a headwind throughout the year. In Colombia, mobile termination rates were cut twice during the quarter. In Paraguay, the government mandated that unused data allotments roll over into the next month. In Chad, an 18% excise tax was levied on telecom services, which pushed up prices and led to a big drop in usage, causing revenue to fall 9.4%. In Tanzania, the firm lost an additional 276,000 customers due to the requirement for SIM electronic registration. Additionally, the firm remains hurt by the loss of a government contract in Guatemala during last year’s third quarter as well as by the continued regulatory requirement to block mobile signals around prisons in El Salvador, which has caused about a 10% revenue decline.

Despite these headwinds, we believe that the fundamental story is intact, revenue growth will return, and margins will continue to expand. Millicom continues to optimize its assets in Africa and announced during the quarter that it will merge its business in Ghana with Bharti Airtel. The combined company will cover 80% of the population with a 3G network and should generate annual revenue of $300 million. Millicom also announced an agreement to sell 1,400 wireless towers in Paraguay to American Tower for roughly $125 million, which will further reduce its debt load. We are pleased with management’s willingness to sell or merge assets to improve returns.

Latin America Focus Results in Excellent Returns Millicom has tended to focus on smaller and more out-of-the way countries than its larger peers. The firm has long had a core business in Central America that was overlooked by America Movil AMX/AMOV and Telefonica TEF, the two mega-operators in Latin America, until growth slowed in the larger markets. In addition to Central America, it has expanded to some smaller South American countries and also a few African countries.

The firm 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. The smaller size of many of these countries means they have seen much lower competition. The lower competition and Millicom’s early entrance have enabled the firm to generate excellent returns on capital in Latin America. It is only the third-largest wireless operator in Colombia, but with its 2014 acquisition of cable television company UNE, it is 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 revenue has slowed as new subscriber growth struggles to offset lower prices for voice and text messaging. However, data services are growing rapidly; when added to these new ventures, we believe this represents significant growth opportunities.

In Africa, wireless penetration rates are much lower, providing the potential for meaningful new subscriber growth. However, competition from multiple operators in many countries has prevented Millicom from generating the high level of returns in Africa that it has posted in Latin America. We still think there is ample opportunity for long-term revenue growth, margin expansion, and improved returns on capital in this region. The company is increasing its focus with the sale of its operations in the Democratic Republic of Congo and pending sale of its operations in Senegal.

Country Scale Trumps Global Scale 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 in most of the countries it operates in. Scale in a country is generally more important than global scale for controlling costs in that country, although the lack of global scale does prevent the firm from having any buying power over its suppliers for handsets and equipment.

Because of the small size of most of the markets in which Millicom operates, it would be very difficult for another operator to enter the market, build out a network, and 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 where Millicom does operate, the firm 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 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). In the longer term, we expect some consolidation in these countries that have more than four operators, which should ultimately help the firm’s returns. This process has begun with Millicom agreeing to sell its operation in the DRC to Orange ORAN.

Emerging Markets Can Bring Risk Millicom's operations are all in emerging markets that are exposed to political, economic, and currency risks. Most of these are fairly small countries and are dependent on trade, but their small size can put them at a disadvantage. In Africa particularly, governments are notoriously unstable and could implement poorly designed laws and regulations. The DRC has struggled off and on with wars for decades. Additionally, in many of Millicom's fastest-growing markets, numerous operators are aggressively competing to gain enough scale to be profitable. The company is controlled by investment firm Kinnevik, whose objectives may not align with minority shareholders. Finally, Millicom announced it has reported potential improper payments in Guatemala to U.S. and Swedish authorities. While we don't expect any significant penalties as the company reported the issue itself, there is a risk it could be hit hard. We estimate that every $100 million in penalties would reduce our fair value estimate by roughly $1 per American depositary receipt. We are currently not accruing any penalties, as we believe they will be below $100 million.