Blogvesting

After reading about Rogers Communications from TMWTFS, I decided to evaluate if RCI is a possible defensive portfolio holding in these turbulent times. Rogers Communications (RCI) is an integrated telecommunications company based in Canada, and has 3 operating segments, wireless, cable and media. Their wireless segment makes up 50% of revenue, and 70% of operating income, and is the chief driver of earnings growth, and so I’ll be devoting all of my analysis to the wireless segment. In addition, all numbers quoted in this article is in Canadian dollars, unless otherwise explicitly stated.

Among the telecoms in Canada, Rogers is considered the top-of-the-line company, boasting the fastest network speeds, and charging premium prices for their products. Rogers has the only GSM network in Canada; the other main carriers, Telus and Bell, both use the older CDMA network. For a variety of technical reasons, the GSM network is heavily preferred by end-users, and most new handsets today are made for the GSM network, Due to its monopoly in Canada, the ARPU (average revenue per user) for Rogers customers is a staggering 20-25% above that of other comparable telecoms in developed economies. Because it is the only GSM carrier in Canada, it has won the Apple iPhone franchise by default.

The telecoms business is both operationally and financially leveraged. Telecoms usually incur substantial debt during the build-out of their infrastructure. After that, once the fixed costs of infrastructure maintenance and debt service are covered, marginal increases in revenue translate to dramatic increases in earnings. To obtain this high desirable revenue growth, telecoms spend heavily in advertising to capture additional consumers. Consumers typically switch carriers for some combination of three reasons: lower cost, faster speed, or a highly desirable handset. Since Rogers has both faster speed and the lion’s share of new handsets, it has commanded a higher growth rate then its competitors, with revenue growth of 12-15% annually, and much higher earnings growth.

Due to its GSM monopoly, Rogers is nearly universally loved by stock analysts, who point to the long-term contracts (typically 3 years duration) as a source of steady cash flow, and nearly universally hated by consumers, who dislike the expensive rates and the various fees levied by Rogers. After numerous complaints, Canadian regulators have recognized the need for competition in the telecoms industry, and have mandated that new entrants to the industry be given roaming access to their competitors’ networks at commercial rates, with compulsory arbitration to establish the rates if an agreement cannot be brokered. In addition, both Bell and Telus have seen the writing on the wall and probably will eventually transition to a GSM network. While GSM is open-sourced and free, CDMA is patented by Qualcomm, and both telecoms and handset manufacturers have to pay royalties to Qualcomm. This is especially aggravating to handset makers, who operate on razor-thin margins in a highly competitive environment and view paying royalties on every chip used in a handset as a form of extortion, and thus almost all new handsets are now based on GSM. In addition, nearly all newly established telecoms in the developing countries have chosen GSM as the standard, and about 85% of the world’s networks are GSM-based, further establishing a large market for GSM phones. Therefore, I consider it highly likely that both Bell and Telus will at some point transition to GSM, and Rogers is likely to face increasing erosion of its monopoly in the future. Already, Rogers has announced that it will eliminate its system access fees for the relaunch of its Fido product.

There are many things to like about Rogers. Firstly, management is clearly shareholder-oriented and offers a high and increasing dividend. I also like that they placed the value of their stock options on the balance sheet as a liability so that they can settle options exercises on a cash-basis using pre-tax cash flow, therefore taking a one-time earnings hit so that they can essentially repurchase shares using pre-tax dollars. Only a company concerned about share dilution will make such a move. Secondly, the company has a enviable competitive position, with most of its customers locked up in 3 year contracts, and having secured the iPhone deal. However, there are also worrisome issues. The company spends substantially on acquisitions without articulating a clear strategy. In 2008, it spent $1 billion to buy some additional wireless spectrum in a national auction, and in 2007, it spent $405 million to acquire 5 Citytv stations. While acquiring additional spectrum is clearly beneficial to Rogers, it seems questionable to me to be spending $405 million on TV stations. Certainly, management did not bother to elaborate on the rationale for the acquisitions, or the expected returns. Rather than spend money on TV stations, I think it would be preferable to be spending money on research and trials of 4G networks, (LTE and WiMAX), so that Rogers can maintain its technological edge over its rivals in the future. In addition, the current economic climate clearly favors Rogers’ competitors. Rogers is likely to face increased turnover of its customers who are unhappy about the exorbitant rates (the 3 year contracts can be terminated with a maximum of $400 in cancellation fees), while Bell and Telus are likely to gain traction with their cheaper products.

Rogers has $8.5B of debt at an interest rate of around 7%, incurring interest expense of $500M annually. For fiscal 2008, Rogers is guiding for revenue of around $11.4 billion. With about $8.6 billion in fixed costs, this gives an operating profit of $2.8 billion, which after $550 million in interest and a 35% tax rate gives $1.4 billion in earnings, or about $2.20 EPS. If Rogers continues on its 10% (or better) revenue growth, earnings will skyrocket to $2.1 billion in fiscal 2009, or an EPS of $3.30. If revenue growth is reduced to 5% or 0%, 2009 EPS will be around $2.80 and $2.20 respectively. I personally think that a reduced revenue growth rate of 5% is the most probable scenario over the next few years. The PE multiple to apply to a given EPS is a matter of personal taste (what discount rate to use, how risky you think the business is etc.), but I personally would assign a conservative PE of 12 to 14 for a blue-chip like Rogers, making the stock worth $33 to $40, making it modestly undervalued at its current price of $32. In the worst case scenario, revenue is flat and the PE shrinks to 10, which gives Rogers a valuation of $22 per share. I think that the margin of safety would be adequate at any price below $27, which gives a greater upside than downside.

I have sold some Jan put options for RCI at a strike price of US$22.50 (approx C$27) for US$1.10. This translates to a 4.9% return over about two months (assuming the options don’t get exercised). Over the long-term, Rogers will face increasing pressures on its profit margin, but has a reputation for quality (but pricey) products and is backed by hard wireless spectrum and cable assets, which makes it a valuable company at an appropriate price.

TIPS, short for Treasury Inflation-Protected Securities, are bonds which provide a degree of inflation-protection and are backed by the full faith and credit of the United States government. The principal of a TIPS increases with inflation (as tracked by the CPI-U published monthly by the Bureau of Labor Statistics) and decreases with deflation, and interest is paid out on the adjusted principal semi-annually. TIPS are sold with 5/10/20 year maturities, and at maturity, the inflation-adjusted principal is paid out, or if the adjusted principal is less than the original principal, the original principal is repaid, thus providing protection against deflation as well. TIPS were invented by the Treasury in the late 1990s because Treasury bonds ran the risk of being eroded by inflation, and there was a demand for a product that guaranteed a return over and above inflation. The TIPS spread, which is the difference between the 10 year TIPS and the 10 year Treasury bill, is a market-based measure of inflation expectations.

TIPS are sold to individual retail investors through the TreasuryDirect website, as well as through many brokerages. However, directly owning TIPS comes with several disadvantages. Firstly, IRS considers adjustments to the principal of TIPS to be taxable, although this is only a paper gain/loss. For this reason, most people should directly own TIPS only in a tax-advantaged account. Secondly, the secondary market for TIPS is not very liquid, and typically you incur a hefty sales commission and bid-ask spread to sell TIPS before maturity. (TreasuryDirect does sell the I-bond, which is similar to TIPS but is saleable back to the government at any time after one year, but I-bond sales is limited to only $5000 per person per year.) If you want to hold TIPS to maturity, and do not mind the tax hassles, then direct ownership is the cheapest way to go. However, there are two ETFs on the market (TIP and IPE) that substantially reduce the hassles of owning TIPS. You can buy and sell these TIPS ETFs like stocks, and they are treated tax-wise like a normal stock or bond, and are extremely liquid. For these advantages, you pay an expense ratio of 0.2%, and a 1.1-1.2% premium over the NAV, as well as brokerage trading commissions.

I am primarily interested in TIPS because I feel that inflation in the future is almost inevitable if we are pull through the current crisis with only a mild recession, and I am looking for some protection against inflation since substantially all of my portfolio is in US dollars. Certainly, a large fiscal stimulus which balloons the deficit is very likely on the horizon, and even normally fiscally conservative economists feel that now is not the time to worry about budget deficits. Furthermore, there are many indications that TIPS are currently irrationally undervalued. The financial crisis has led to investors fleeing every investment except for Treasury bonds, even investments such as Agency bonds and TIPS, which are also backed by the government, leading to an incredibly high TIPS yield. At one point, due to the rush to Treasury bonds, the yield on 5-year TIPS were briefly higher than that of the 5-year Treasury bill (TIPS normally yield lower than Treasuries because of their inflation protection). Even the Federal Reserve has stopped tracking the TIPS spread, which is basically tacit acknowledgement that the current prices for TIPS are irrational. Both TIPS ETFs are now boasting a dividend yield of 8-10%, for bonds that are backed by the full faith and credit of the US government, while ETFs for long-term Treasuries, also backed by the government, sport a dividend yield of only 3-4%.

Are there any risks to this investment? I consider credit risk to be nil, since TIPS are basically as safe as Treasuries. Because ETFs are traded on the open market, there is theoretical risk that the market price may deviate substantially from NAV, although large deviations for extended periods are impossible because the ETFs are open-ended and the manager can create and redeem units. In practice, both TIP and IPE command a 0.5-1.5% premium over their NAV. The only risk involved is deflation risk, which would erode the principal of the underlying TIPS and decrease NAV. However, deflation would be cataclysmic for the US economy, and the Federal Reserve will certainly do everything possible to prevent that from happening. Indeed, I cannot justify the purchase of any stocks in the US if I really think that deflation will occur, since deflation is usually accompanied by a very high unemployment rate and a stagnant economy for many years (e.g. the Great Depression in the US, and the lost decade in Japan).

In conclusion, TIPS ETFs are exceedingly safe investments that are currently (and probably temporarily) sporting an abnormally high return. I have begun to scale into TIP, and will probably continue to scale all of my cash into TIP while I scout for extremely undervalued stocks in defensive industries to invest in.

The finance literature is littered with examples of many calendar effects in the stock market; the following is a partial list :

• The weekend effect : The mean return from buying stocks on Friday and selling them on Monday is larger than buying stocks on Monday and selling on Friday. This is especially unusual since the Mon-Fri period spans 4 days and entail more risk than the Fri-Mon 3 day period. This effect is usually explained by short-term traders dumping stocks on Friday to avoid holding them over the weekend, and retail investors doing their research over the weekends and placing buy orders on Monday.
• The year-end effect : Stock prices tend to drop in the last days of December due to tax loss selling and portfolio window-dressing by professional managers selling losing stocks. The drop is rapidly reversed in January with many investors “wiping the slate clean” in their minds and placing new buy orders, and professional managers re-purchasing the same stocks they sold in December.
• The October effect : Many of the most severe stock market declines have occurred in October, including the Panic of 1907 (Oct 1907), the Great Depression (starting Oct 1929), Black Monday (Oct 1987), and the Panic of 2008 (Oct 2008).

The October effect is also known as the Mark Twain effect, which comes from the following quotation in Twain’s novel Pudd’nhead Wilson : “October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.”

In general, these calendar effects have become much less consistent since their publication, and have tended to shift into adjacent days/months as traders take advantage of them. Most academic studies now agree that it is difficult to systematically take advantage of these effects today. However, it seems to me that in general, the autumn months are bad for stocks. There is something about the turning of the seasons and the falling of the leaves that makes greed wane and makes fear wax and brings on seasonal affect disorder. I think that there truly is a greater-than average chance of a black swan event in the autumn months due to the physiology of humans. The only recent significant decline in the stock market that has not happened in autumn is the bursting of the dot-com bubble, which happened in March 2000, and even that was a very gradual decline. Of course, I realize that I may be subject to the proximity effect, which makes more recent events seem more significant, but you can bet that when the next autumn rolls around, I’ll be scouting for some cheap put options to tide me through those months.

I have liquidated SEB from my portfolio at $1365 a share, which is a 6% gain from my entry price. In the end, I felt that this company has too many cash flow streams which is beyond my circle of competence to analyze, and the fact that management is so uncommunicative is starting to worry me. I felt that, in the current climate, there are plenty of well-run, easy-to-understand companies trading at attractive prices which interest me, and so have decided to liquidate for a small gain.

Since my last review of ZINC, zinc commodity price has sunk rapidly from $0.70 per lb to $0.50 today. Even with half of 2008 and 2009’s production capacity hedged at $0.90 per lb, Horsehead probably requires a zinc price of $0.70-$0.80 per lb to break even. With zinc prices at $0.50 and many major zinc mining companies closing their mines, I had expected Horsehead to put their plans for the new South Carolina plant on hold. Instead, I was disappointed to find that Horsehead has moved ahead with construction of the new plant in a climate of over-capacity and when they lose money on every pound of zinc sold. The new plant will cost $90 million, which would more than wipe out the $65 million cash the company has, and draw down on their $60 million credit line. This large capital expenditure, coupled with the fact that both the CEO and CFO have sold all of their shares in May 2008 and now hold no shares in ZINC whatsoever, has given me pause, and I have sold half of my position in ZINC at a price of $2.95, for a 62% loss.

However, the picture is not without hope. Although I would have preferred that management cease all large cap-ex and conserve cash at this juncture, it is still possible that management will see the light and place construction of the new plant on hold. There may be contractual obligations forcing them to break ground on the new plant, and construction may be slowed down dramatically to reduce the rate of cash burn. Finally, zinc prices seem to be edging back up again, probably in response to the surprising news that orders for durable goods increased 0.8% in September, and that almost all zinc mines are being shut down in response to the dramatic drop in zinc prices. Horsehead still has a low cost structure compared to rivals, and if they can survive the lean times, the company should have a bright future. I am keeping my eyes peeled for some insider purchases of the stock (as opposed to more hedge fund purchases), as well as closely monitoring the zinc price, to gauge if I should re-establish a full position.