Shares of T-Mobile US (NYSE: TMUS) popped almost 9% last month on news that Sprint (NYSE: S) would seek a buyout of the wireless carrier. Coming less than a year after Japanese giant Softbank (OTC: SFTBF) acquired Sprint, the move heats up the battle for telecom supremacy.
Investors are cheering on both sides of the potential deal, but they may be in for a rude awakening when the Federal Communications Commission (FCC) weighs in.
Four has always been a magic number for telecom carriers. The idea is that if the industry consolidated to fewer than four carriers, an oligopoly would form and prices would go up. That's part of the reason regulators jumped in when AT&T (NYSE: T) tried to buy T-Mobile in 2011. While a Sprint/T-Mobile combination would still be smaller than either AT&T or Verizon (NYSE: VZ), it would still put considerable pricing power in the hands of just three companies.
I alerted investors in October to T-Mobile's great turnaround story and the success in its Uncarrier program. TMUS is up more than 25% since that article -- but the valuation looks stretched, especially if regulators put the kibosh on an acquisition deal.
Fortunately, I have found another wireless provider that is an even better buy. Not only is it the market leader in multiple segments, but it offers dollar-based investors a high dividend and international diversification.
Don't get me wrong -- I'm a huge cheerleader for U.S. equities and think the bull run has at least another year left, but I am always on the lookout for international stocks with strong fundamentals that can help me reduce the volatility in my portfolio of mostly domestic companies.
And the strongest overseas market isn't even "overseas."
Canada's stock market has a high correlation with U.S. stocks but still provides diversification and reduced volatility. Canada's debt-to-GDP ratio is just 34%, a third of the U.S.' 107% debt-to-GDP ratio. The country's economy is forecast to grow by almost 3% this year, which should help the Canadian dollar appreciate against the greenback. That appreciation makes shares of Canadian companies even more valuable in U.S. dollar-terms.
In the six years leading up to the 2008 market crash, the iShares MSCI Canada ETF (NYSE: EWC) had outperformed the larger U.S. S&P 500 Index by 160%, and investors had more than tripled their money. Over the past year, Canadian shares have underperformed the S&P by 25% on a weaker currency and stronger sentiment for U.S. stocks.
The market has firmly turned against international equities despite a solid economic outlook for our neighbors to the north. As a contrarian investor, I want to be there when the market catches up to fundamentals.
Wireless penetration in Canada is just 80% compared with 102% in the United States, meaning the industry still has some strong growth ahead before it reaches saturation. The industry in the U.S. has been going through a consolidation phase over the past several years as capital spending requirements become more manageable for larger companies. Dish Network (Nasdaq: DISH) has been aggressively trying to find a wireless partner after losing a bid for Sprint to Softbank for $25.5 billion. This consolidation phase is just beginning in Canada with the acquisition of Public Mobile by TELUS (NYSE: TU) in October for an undisclosed amount.
So take the long-term potential in Canadian stocks and add in an industry consolidation, and you have my favorite international dividend play...
An Undervalued Industry Leader With A Surprise Upside
The largest of Canada's three national wireless carriers, Rogers Communications (NYSE: RCI) comprises Rogers Wireless (65% of 2012 revenue), Rogers Cable (30%) and Rogers Media (5%). The company's telecom assets are the hands-down winner in the market with a 40% share of wireless and half of the smartphone market. Rogers Cable is the nation's largest cable network with 2.25 million TV subscribers and almost a million Internet subscribers. The company has nearly 85% of its subscribers on postpaid contracts, which has helped it maintain margins and growth in a competitive market.
Shares are down 3% over the past year on a competitive environment for telecoms and lower roaming rates. The slowdown in growth could prove to be an opportunity for investors with the shares posting a 10-year return of 22% on an annualized basis. The fact that the company was able to cut retention spending by more than 10% in the third quarter while still lowering customer churn by 0.11% leads me to believe that the tough competitive environment is moderating and results will start to improve.
Management has made a firm commitment of returning cash to shareholders through a 3.8% dividend yield and an aggressive buyback program. Almost 10 million shares were repurchased last year for $350 million, reducing the float by 3%. Last year's buyback was down significantly from prior years, and the company has regularly spent $1 billion a year or more to repurchase stock. This policy of cash return has been managed even as the company invests more than $2 billion annually in capital spending.
Verizon and AT&T have both considered entering the Canadian market but have held off on the large capital investment needed. Rogers Communications trades for 6.8 times earnings before interest, taxes, depreciation and amortization (EBITDA), lower than the 7.0 multiple at which Sprint agreed to be acquired. Shares of T-Mobile have traded in a tight range around $33 per share since the acquisition rumor broke. That values the company at more than 9.2 times EBITDA, a premium of 35% on shares of Rogers Communications.
Of course, the major roadblock to a bid would be the Rogers family and their intent to keep the company. After the death of founder Ted Rogers in 2008, the company brought in an outside CEO, but three family members still sit on the board and control 60% of the voting rights. An eventual sale or breakup would not be unheard of at a reasonable valuation, and with its heavy wireless exposure, Rogers is the most attractive Canadian target. The family could sell the wireless assets while still maintaining its legacy through cable and media.
Shares are more than 15% off last year's high and are a good value on fundamentals alone. The discounted cash flow value of just over $52 a share is close to my own estimate for 2014 earnings of $3.85 per share and price target of $57.67 on an earnings multiple of 15.
Risk to Consider: The Canadian wireless market is highly competitive, and profits could be sluggish over the near term until the industry starts consolidating. Rogers Communications is still closely held by family owners, and investors have little control over the company.
Action to Take --> Rogers Communications offers a strong yield in a country and industry with the potential for growth. Investors in U.S. wireless carriers have benefited from a wave of mergers, and it is only a matter of time before the consolidation phase hits Canada as well. Even if the Rogers family holds out on an acquisition, RCI should continue to provide an attractive cash yield with price upside on currency gains and industry forces. Investors should set a buy-under price of $50 and may want to consider taking profits if the stock makes a break to $60.