America Movil Attractive Even After Disappointing Quarter

The first quarter was a mess in Mexico. Movil shed 202,000 net wireless customers, its first quarterly loss in more than a year, despite matching the aggressive promotions that competitors have put into the market. These promotions produced an 11% sequential drop in average revenue per wireless customer (15% year over year). At MXP 133 per month (about $7.50), average revenue per user has declined 25% over the past four years even as the proportion of postpaid customers in Movil's base has expanded to 16% from 12%. Telefonica TEF and AT&T T gained share during the quarter, and while both also saw a decline in ARPU, the pace (each down 7% sequentially) was slower than at Movil. While we don't believe these rivals can price aggressively indefinitely, the sharp ARPU drop at Movil is a cause for concern.

The drop in revenue per customer drove a 2.6% decline in Mexican revenue. Offsetting lower wireless services revenue, the year-over-year decline in the peso pushed up smartphone revenue. Fixed-line revenue also held fairly steady. However, the decline in revenue, the impact of higher peso-denominated smartphone costs, and the Telesites spin-off crushed profitability. The Mexican EBITDA margin dropped 6 percentage points to 35.7%.

Latin American Dominance Second to None America Movil's dominance of the Latin American telecom landscape is second to none. While recent currency volatility and regulatory uncertainty serve as a reminder that caution is warranted, we expect the firm will be able to ride out short-term turbulence and provide an attractive means for investors to benefit from economic growth across the region.

Movil's Mexican business (30% of sales, 40% of profits) ranks among the strongest telecom operations in the world. The firm controls around 70% of both the wireless and broadband Internet access markets in the country, a level of dominance few carriers can boast. Relative scale is the primary means of carving out a competitive advantage in the telecom business--Movil earns EBITDA margins in Mexico 50% higher than Telefonica's, its closest competitor.

Dominance comes at a price, however. Mexican telecom law has changed dramatically over the past couple of years, squarely taking aim squarely at Movil in an attempt to level the competitive playing field. This shift has drawn AT&T into the market, adding a deep-pocketed rival to the mix and partially placating regulators for now. We suspect AT&T will struggle to grow profitably in Mexico, and if the competitive landscape doesn't improve over the next couple of years, we wouldn't be surprised to see new regulatory action taken against Movil.

Capitalizing on the immense cash flow generated by its domestic operation, Movil has pushed into other Latin American markets, creating a regional behemoth with about 250 million wireless customers in the region. Only Telefonica comes close to this scale (around 200 million). While Movil isn't the largest carrier in every wireless market it serves, including Brazil, its unmatched scale provides critical stability that enables it to ride out economic, competitive, or regulatory weakness across smaller countries. In addition, the firm's fixed-line assets in many countries, including Mexico, Brazil, Colombia, Peru, and Chile, bring the ability to provide service bundles to customers. The addition of fixed-line assets to the wireless business should aid in meeting surging wireless data demand across the region.

Size Advantage Conveys Cost Advantage While America Movil provides services in more than two dozen countries, its operations in Mexico, Brazil, the United States, and Colombia provide about 70% of total revenue. Mexico is the firm's most important market, accounting for 30% of revenue and about 40% of EBITDA. Within Mexico, the wireless business accounts for two thirds of revenue, with fixed-line services and other businesses producing the remainder. America Movil dominates the Mexican wireless market in an almost unheard-of manner. The firm holds nearly 70% share, based on both customer relationships and revenue, with revenue about 5 times that of each of its two smaller rivals, Telefonica and AT&T.

This size advantage conveys a huge cost advantage to Movil. The firm reports EBITDA margins of around 47% in its Mexican wireless segment, a fantastic level that is probably understated (the firm lumps corporate costs into this segment). Segment operating income runs at greater than 100% of the value of segment net proper, plant, and equipment and spectrum assets. As a comparison, Verizon Wireless VZ, the best of the U.S. carriers, earns similar EBITDA margins but its operating income runs at only a bit more than 20% of its net PP&E and spectrum assets. Movil's scale has enabled it to maintain a substantial network lead over its competitors, with its LTE service available to more than 70 million people (nearly 60% of the country) versus less than 45 million at AT&T (the former Nextel and Iusacell networks). Telefonica claims LTE coverage across 37% of the Mexican population.

AT&T's recent entrance into the Mexican market is a double-edge sword. Unlike the two Mexican firms it acquired, AT&T is a strong competitor with deep financial resources, scale, and expertise. However, AT&T is likely to remain a rational player and it has consolidated the market down to three players, a level that typically holds competitive intensity in check. AT&T has also budgeted only $3 billion through 2018 to expand its network in Mexico, a fraction of the amount Movil could spend annually if it chose.

While Movil dominates Mexico, we expect regulation will ultimately curb its competitive position. The Mexican government amended its constitution in 2013 and enacted new legislation in 2014 to overhaul telecom regulation in the country, resulting in the creation of a new regulatory body, the IFT. The IFT has taken a strong stance against Movil's wireless dominance, quickly declaring the firm a "preponderant" player subject to asymmetric regulation. This asymmetry includes a requirement that Movil allow competitors' customers to connect calls to its customers for free while Movil must continue to pay interconnection fees to its rivals. Movil must allow competitors to access its passive infrastructure and certain other network elements at rates approved by regulators. Also, the Mexican government has been stingy with spectrum allocations and plans to use the 700 MHz band to create a wholesale network available to all carriers rather than auction these licenses off to the highest bidder. Finally, Movil remains banned from offering television services, a position that provides an advantage to its cable rivals.

Movil is similarly dominant in the Mexican fixed-line segment. The firm is the only significant traditional phone company in Mexico, yet its network only reaches about 20 million of the country's roughly 31 million households. Internet access penetration of homes passed stands at about 45%, providing America Movil with 70% market share. The firm faces two primary cable rivals, Megacable and Grupo Televisa TV, which pass roughly 18 million homes and claim about 22% Internet access penetration. Both cable companies have steadily gained share in recent years, owing to a superior network and the ability to offer triple-play bundles. We suspect that Movil holds an even stronger position in the Mexican enterprise services market than it does in the residential business.

Brazil is Movil's second most important market, producing 20% of revenue and 18% of EBITDA. The firm holds a strong position in the fixed-line segment thanks to its acquisition of Net Servicos, the largest cable company in the country, and Embratel, the incumbent long-distance carrier in Brazil and now a large player in the enterprise market. Movil's cable network reaches about 21 million homes, with about 36% of these taking its Internet access service. We expect the firm's cable network will provide an advantage versus the incumbent phone companies (Oi in most of the country, Telefonica in Sao Paulo) in serving most customers for the foreseeable future. However, Telefonica's recent purchase of GVT, an aggressive network overbuilder, provides it with a solid network platform as well. GVT has been expanding its network and taking market share in recent years, a reflection of the lacking efficient scale advantage held by the incumbent carriers in many parts of the country.

Movil is the third-largest Brazilian wireless carrier, though the top three firms in the market (Telefonica and TIM Brasil TSU) are all reasonably comparable in size. The wireless market has a long history of stiff price competition, resulting in generally declining average revenue per customer. We estimate that Movil generates about two thirds as much revenue per Brazilian customer as it does in Mexico, adjusted for an extremely high level of wireless penetration in Brazil. Without the advantage of massive scale versus its rivals in Brazil, Movil generates weak margins in the country, especially relative to its performance in Mexico. However, we believe that it and Telefonica are substantially better positioned in the Brazilian telecom market overall than either Oi or TIM, thanks to the wide range of fixed-line and wireless assets at their disposal.

America Movil is also the dominant wireless carrier in Colombia, a market that generates about 8% of its revenue and 10% of EBITDA, with nearly 60% share. The firm also owns cable networks reaching a bit less than half the population. As in Mexico, this scale has enabled the firm to produce strong profitability. The combined Colombian fixed-line and wireless operation produces nearly 40% EBITDA margins, with operating income equal to about 35% of net PP&E and the value of spectrum. However, as in Mexico, regulators have taken aim at Movil, requiring asymmetric termination rates and limiting its ability to acquire additional spectrum.

America Movil's remaining operations are spread across several countries, primarily in Latin America. The firm is the largest wireless carrier in several of these markets, including Ecuador, Argentina, Nicaragua, the Dominican Republic, and Puerto Rico. The firm's U.S. operation, Tracfone, accounts for about 12% of total revenue but is only marginally profitable. We don't believe this business possesses a competitive advantage, as it is ultimately at the mercy of the wireless carriers that sell it excess capacity. We expect the U.S. carriers will increasingly use their own sub brands, like Leap and MetroPCS, to attack the low end of the market.

Regulatory Uncertainty a Major Threat America Movil faces considerable economic, political, and currency risks, given that most of its operations are in emerging markets. Recent currency movements have hurt the firm's bottom line thanks to movement in the value of its debt obligations, added to the cost of buying network equipment, and diminished its value to U.S. investors. Economic turmoil in Brazil has hurt demand for services, slowing growth in the country, and caused an increase in the number of customers failing to pay bills on time.

Regulatory uncertainty also presents a major threat to long-term growth and profitability. Telecom services are often viewed as a public necessity critical to driving economic growth. As a result, politicians and regulators often take aim at the industry to foster network investment and service adoption. Dominant carriers like Movil are usually the primary regulatory target. Wireless licenses and operating concessions typically must be renewed periodically in most Latin American countries, providing regulators an opportunity to impose new costs or obligations.

The telecom industry is not immune to technological risk. If technological advances enable a competitor to serve customers effectively, existing carriers could quickly lose market share as pricing contracts. For example, the cable companies in Mexico may be able to effectively offer wireless service using Wi-Fi in some densely populated areas.