Cellcom and Partner Communications: A Comparison of Two Israeli Cellular Giants

When creating Israel Newsletter, and our Investment Advisory business (American Israel Investment Associates), we were frequently met with skepticism about focusing solely on Israel.

This wasn’t the real cynical kind of skepticism, but rather a good question that any asset manager should be able to address: Why focus on Israel? Or put a better way, U.S.-traded Israeli companies tend to skew heavily towards technology, and as we all know, technology companies operate beyond geographical boundaries, and these types of companies are essentially independent of their local markets. This is not so true for a domestic Chinese life insurer who sells policies into a large local market, but partly true for Israeli software/hardware companies that are primarily export-driven.

Well, we feel we’ve answered these questions sufficiently for our readers, and investors who are voting with their support for our value-driven, on-the-ground analysis of Israeli companies. But for those who linger on the fences, we decided to publish some of our work on what are probably the two most interesting domestic plays in our universe: the two largest Israeli cellular operators, Cellcom (CEL), and Partner Communications (PTNR).

Let’s first profile Cellcom before we benchmark it against Partner.

Strategy

Maximize customer satisfaction, retention and ARPU (average revenue per user) growth.

Grow content and data revs.

Strengthen the Cellcom brand.

Improve net income by controlling while keeping service levels at acceptable levels.

The Israeli Wireless Market

Mature: not a lot of room for increased penetration (wireless penetration stands at 120%)

Slow Growth: Growing around 5% this year.

Competitive with Four Cellular Operators: Cellcom 2.9MM customers and 34% market share but adding estimated 48% of net market additions in 2006. Other competitors include Partner (PTNR), Pelephone and MIRS.

Put all this through the analysis blender and this is a story about ARPU growth — plain and simple.

Data Revenue Growth Potential

We believe that this is the main driver for cellular market growth in Israel. Israel sits in the relative middle in terms of data ARPU as a percentage of overall ARPU when compared to other countries.

Merrill Lynch analysts attribute Israel’s low data usage to the country’s high voice usage - precluding SMS usage. Merrill uses the Monthly Per Capita Usage metric (that is, monthly operating usage times penetration), and Israel scores really high. It is the 3rd highest of all 53 countries that were tracked.

Regulatory Challenges/Opportunities

There are four regulatory challenges affecting the Israeli cellular industry:

1. Ongoing Interconnect Cuts: Rates were recently cut 10% in March of 2007, and will move to 15% next year. While creating margin and ARPU pressure, the cellular industry has been relatively successful in passing on this cost to the user in the forms of tariffs.

2. Introduction of Voicemail Notification: The Israeli regulator introduced an option for callers to voicemails to hang up within the first three seconds of a call without being charged. Cellcom warned that this would affect revenues negatively to the tune of 1.2% and EBITDA 3.2% for 2007. Again, it’s probably likely that rising tariffs and data usage offset this negative impact.

3. Mobile Number Portability [MNP]: Due to be implemented in the second half 2007 (although no firm date has been announced), this could theoretically compel Cellcom’s competitors to boost SAC (subscriber acquisition costs) to capitalize on lower barriers to switching. We don’t see any indication that any cellular operators plan to break rank and ratchet things up.

4. Potential MVNOs (Mobile Virtual Network Operators): MVNOs do not exist in Israel today. The government has said that it is interested in allowing creation of these entities and 20% return on invested capital will probably spell that cable operator HOT gets into the game, further pressuring prices.

So, let’s pit Cellcom head-to-head with Partner, and see where that takes us.

Growth: Cellcom’s move into 3G came almost a full year after Partner’s. By default, data revenues for Cellcom have taken longer to ramp up and consequently, contribution from new sources of revenue (ie, data) presage to be higher for Cellcom than for Partner. Merrill estimates that Cellcom will post 6.3% sales growth compared to Partner’s 5%.

Dividend Policy: Partner’s dividend policy is to pay out at least 40% of net earnings while Cellcom pays out 95%. Partner will probably have to parry for Q2 to meet similar payout.

Balance Sheet: Cellcom’s owners already paid out a significant dividend pre-IPO and we expect Partner to probably issue something similar. At the end of 2006, Partner had net debt/EBITDA of 1.2x compared to Cellcom’s 1.6x.

click to enlarge

In sum, it looks like both business share similar balance sheet profiles and exposure to new growth opportunities. Yet, Cellcom trades at a 6% EV premium. Given such similarities of two companies competing in the same market, investors need to ask themselves if Cellcom’s premium is warranted.

Perhaps it’s not - maybe it’s the after-effect of trading dynamics when an Israeli company dually lists in Israel and the U.S. (see our analysis of this effect here). I don't know, but a pair trade (long Partner and short Cellcom), looks pretty interesting right here into the summer.

CEL vs PTNR 5-month chart: