John Winsell Davies Suntec City Tower Four 6 Temasek Boulevard 35-03 Singapore 038986

新加坡共和国

சிங்கப்பூர் குடியரசு

Skype: “John Winsell” j.winsell@bloomberg.net +65 6643 5362 direct jwd@devonian.ru

22 July 2015

JWD Weekly Call

The Tribble with Telco’s

‘Your phone’s of the hook, but your not,’ Exene Cervenka / John Doe, X - Los Angeles 26 April 1980

Verizon Communications Inc. (VZ US) Sector: Telecommunications Industry: Telecom Carrier Action: Short

The Macro

In 1984, the U.S. Justice Department broke up ‘Ma Bell,” the fixed line telephone monopoly that dominated consumer telecommunications in America and Canada, since being founded by Alexander Graham Bell in 1877. 99% of Americans already had access to a fixed line telephone in the 1980’s, and the Bell System’s domination of virtually all facets of the industry stifled competition. Citing anti-free market and anti-consumer business dealings, the DOJ first brought suit in 1977. The Bell System’s ultimate demise was determined to be in the interests of the public good. But like most people at the time, I remember initially being unhappy about the break up, because service went down and prices went up.

American Telephone and Telegraph was divided up into seven regional telecom operators ‘Baby Bells’, Bell Labs, Western Electric, and AT&T long distance. With $149.5B in assets at the time of the break up, Bell was the 4th largest company in America after Exxon (XOM), General Motors (GM), and Mobile (XOM).

In some ways, the world has changed less since that day than one might anticipate. The two largest components of the old Bell System today (Verizon Communications (VZ UZ) and AT&T (T), have a combined market cap of $376B, making the entity the 4th most valuable company in America after tech titans Apple

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$760B, Google $461B, and Microsoft (MSFT) $379B. So what has changed? 97% of Americans still have access to a fixed line telephone in 2015 (a slight decline), but fully 99.5% have access to a mobile phone and 64% are ‘smart phone’ owners (1 April 2015 Pew Research Centre Report).

Investors in the market leading telecom carrier and wireless operators including AT&T and Verizon enjoy high share prices, solid earnings, and generous distribution of free cash flow in the form of large quarterly dividends.

Executive Summary

So 30 years after the break up … break out the band and blue skies forever? – No. I am going to take the unpopular position that the good times are over, the sector peaked in 1999 and it is going to get worse from here. Everything changed, but the changes are poorly understood and difficult to recognise at distance. Incumbent telecom carriers and wireless operators should consider a future of increasingly unattractive fundamentals, declining profitability, and shrinking market capitalisation. Indeed, very much like the traditional television broadcasting and cable companies or traditional publishing and print media companies, the traditional telecom carriers and wireless mobile operators have already entered a period of long-term structural decline. Voice plans and data plans share the same future as bundled cable packages and the daily rag. Why? Because technology is irreversibly changing consumer preferences, buying habits, behaviours and choice. Innovators will not only benefit from the new economy in telecommunications, but will also likely determine the way that consumers communicate, what devices they use to communicate, who and how they will pay, for both the hardware and connectivity. This future will be divined at the expense of the old economy incumbents. A telephone carrier and wireless operator (heretofore a ‘telco’), is neither the creator of the new technologies nor the architect of the new business paradigm. The telco is removed from ‘value-added’ segments of the business. The telco is not the designer of new high margin hardware. The telco is neither the developer of content, nor the archivist of complex client data files. The telco is instead conjoined to the unwieldy and unprofitable, Mcap-intensive, infrastructure assets and their associated upkeep. The telco is like the great railroad operator before everyone figured out, that there was a better way to fly. His expansive networks, like the silver rails that connected San Francisco to New York City, is a giant hungry mule that he must constantly feed. It moves somebody else’s goods from point A to point B for a fee, until that somebody finds something faster, cheaper, and cleaner than an ass, to cart the load. Whatever does he mean by this cantankerous characterisation? A telco drives revenues from unambiguous businesses, which are sometimes cryptically titled units such as enterprise, federal, consumer, wholesale, small business, etc. But they are really just four tariff charging segments and I see it like this:

Wireless

Long distance

Data packet transmission

Local Wireless profitability is imperilled by price wars (above) as well as the simple fact that … the consumer no longer needs to pay money, to a wireless operator, to make a wireless call. Voice over IP (VoIP) technology

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built into iOS, Android, Windows, and Blackberry smart phone aps, by players like Apple Facetime, Viber Media (private Las Vegas Nevada, US-based, Byelorussian outsourced, Israeli’s), and others, is available for free in 40 languages with global reach. The field will grow.

Long distance profitability is threatened by Voice over IP (VoIP) technologies allowing for free long distance communications with or without video. Mainstream acceptance was pioneered by Skype (acquired by Microsoft). In addition to Google Meetup and many others, free long distance is available on virtually any operating system Windows, Mac, Linux, Android, iOS, Windows Phone, BlackBerry, Nokia X, Fire OS, Xbox One, PlayStation Vita and PlayStation Portable. Skype is already approaching 50% of US long distance call volumes and this is just the beginning. Some say that entrants like Microsoft are just waiting until they have reached critical mass before figuring out how to monetise their Skype base by charging for long distance calls. Maybe they are, but that is not going to help the telecom carriers – is it?

Data packet transmission revenues are being shorn by social media platforms like WhatsApp and Facebook Messenger who offer free messaging on far better platforms. And broadband revenues did not get a boost on 26 February 2015 when the FCC voted to retain net neutrality rules. So where is the good news?

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One such mule … Sprint

Sprint (S US) America’s third-largest wireless network has dropped -64.65%. Without the backing of Japan’s Softbank (2284 JP), the shares might be trading lower

What do you do when you have nothing left to sell on other than price? Sprint (S US) the third-largest wireless network operator in America with 57.1MM subscribers, announced at yearend 2014 that it would embark on an ill-advised price war. The telco offered half-price wireless service to customers who switched to its service from Verizon and AT&T. The move to gain subscribers burned cash and Deutsche Telecom’s T-Mobile USA, joined the fray. Sprint’s $9B in cash on 1 Jan 2015 might be halved as early as mid-2016, just in time for the US government’s 2016 auction of wireless spectrum. Wireless carriers burn huge capex on airwaves to meet unending subscriber demands for ever increasing data transmissions. Sprint is anticipated to need +/- $10B to participate in the 2016 auction.

Anecdotal unplugged In addition to broadcast/cable television, I have also been ‘unplugged’ without a home telephone since 2008. I do not use my i-Phone to SMS, make or receive calls. The only reason that I bought a SIM card for my mobile in the past many years is because (very specifically here in Singapore) a unique mobile phone number is mandated by the Ministry of Manpower to receive an employment card. And because unique mobile phone number is also by DBS Bank Singapore to open an account. So Elizaveta bought an M1 pay-as-you-go SIM for $10 SGD, my number is +65 6643 5362 and I have not made a call or sent an SMS since. Why would I? I can open accounts and forms. It can receive incoming SMS for free. Another … Old fixed line telephone is expensive. Have you ever watched the telephone poles blur by from the seat of a train? The US Federal Communications Commission (FCC), allocates $4 B p.a. to make sure that every American, no matter how remote, access to telephone service, which are subsidised at up to $3,000 per line.

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According to a study by the Alliance for Generational Equity, 99.9% of U.S. households have access to mobile voice service which is unsubsidised. The study takes the position that fixed line service is no longer a necessary component of America's telecommunications infrastructure, considering VoIP and mobile alternatives. Ultimately, AGE concludes that "economic welfare would increase if the entire $9 billion per year FCC program were eliminated." “One of the primary benefits of using an IP PBX is that it lacks the cumbersome and expensive physical hardware that has apparently resulted in billions of dollars of waste at the federal level.” Enterprise Specific Verizon is a nearly $200B, large cap Dow component that is widely held, widely followed and receives considerable research coverage from the investment community. Some might question how a single manager can profit from taking a position in a name? This when teams of analysts with industry sector-specific expertise have spent years tracking streams of cash flows and developing modelling tools, to perhaps, more accurately predict future earnings? Simply because the number of market participants has no negative impact the success or failure of the investment. Conversely the more stakeholders, the higher the volumes, the larger the market capitalisation and associated ASO’s, the lower the friction costs and more efficient the investment. The issue that impacts profit and loss is being on the right side of the trade, and that starts with the macro. The avoidance of large caps is the same as saying that it is not possible to drive powerful returns from sovereign credit, global Fx, or base commodities, because these large markets are so well covered. But as always the only practical consideration is being right or wrong. A manager does not have to invent a new undiscovered theory that no one else has ever thought about to profit. No, he simply has to be correct in his analysis and the same holds true for stock selection. But that being said, I suggest that in this particular name and in spite of the broad coverage universe, we are going consider the investment case in a third light. Whereas the ‘street’ is principally looking at Verizon two ways, we are going to understand this short somewhat differently. Buyers say

Low beta .37 implying lower systematic risk

The market is broadly constructive on Verizon

ANR consensus 4 [BUY] rating with only 5% with [SELL] rating (2 of 39 analysts tracked on Bloomberg)

Giant 4.68% dividend

Institutions, yield buyers and value buyers (on an earnings basis – 11.92x 2015’E P/E) all love it

VZ is a core holding in many retail mutual funds and pensions

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Sellers say

Grossly overvalued (on an asset basis) - the Price/Book is no defensible at 20.78x

Dangerously overleveraged, the books are laden with massive borrowings, and total debt to common equity stands at 921%

VZ has a combined short-term and long-term debt of $113 billion

Trades as 4% corporate bond with no maturity date. Near $200 B M-cap, Verizon is trading $47.59, in the middle of a three year trading range, within 10% of the 2013 high

I say

They are both right but that is not what we are focused on in our investment case Verizon like all the telco’s in this unattractive, m-cap heavy space, has had to assume huge debts to build, maintain and improve infrastructure. Dangerously thin line, able to service $131B debt on $127B revenues. Razor’s edge, able to finance dividend with 90% pay out on $9.6 B in net income with $8.6 B paid out. It looks like management is bleeding the victim like a vampire, keeping it on the edge of eternal sleep. Or perhaps more like Abramovich ran Sibneft (SIBN) in the finals days, because he know that he would be taken out by Gazpromneft. This is a no growth, no future strategy … cash cow management of I suggest, an imperilled core business model. And the pay-out looks somewhat like desperation. If you have not growth strategy, why not pay down some of the monster debt? The shares have plateaued in a trading range based on 4% yield for three years, so that makes since. You are buying a corporate bond with an equity teaser. But what will happen when rates go up as has oft been debated here with the same ultimate conclusion? Or just as likely, what happens on a revenue miss? Can’t borrow any more money with the 2016 US government auction of wireless spectrum – right?

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And voila, the company reported a net loss of 138,000 wireless phone subscribers in the last quarter 21 April 2015. These are customers who switched to either T-Mobile or Sprint in the price war. When you are a commodity product, a mule in this case, you have to compete on price. The US wireless market is positively saturated as we have already discussed. How to drive subscriber growth? >60% of Verizon’s growth in 2014 came from tablets, but iPad sales are slowing to a crawl. What next? And that was luck. Verizon’s future fleeting growth blips are at the fate of a technology company who invests a new product that might require the services of a mule. Sprint and T-Mobile believe that value destructive cash burning price war (like the one that crippled the US airlines for much of the last 20 years) is the answer. On one hand firms may desperately try to take from each other’s table by slashing price plans. On the other hand that are being forced to cut roaming (long distance) as the consumer is quickly moving to WiFi? What else can Verizon do to raise sales? As detailed, theirs is a pretty simple business and the answer is not much. What might Verizon do to get those customers back and try to shield top line in order to protect the dividend, because when the dividend is cut, institutions and retail investors alike will move to the exits?

Disclaimer: telecom carriers and wireless operators should expect a longer shelf life and more durable profitability in the R.O.W. The current assignment is US centric and like CBS Inc. in the television broadcasting and cable space, Verizon is a US player with no meaningful global foot print. New technologies and changing consumer preferences in America should directly impact firm profitability.

Project Fi Can it get any worse? Hell yes it can. What about Project Fi? Project Fi, from Google the Friendly Giant is may soon shatter any remaining hopes for Verizon and the tech retardant entrenched players. Project Fi is a mobile phone service that promises unlimited domestic talk and text, unlimited international messaging, tethering and 2G-only international service in over 120 countries for $30 a month. T-Mobile and Sprint combine to provide coverage area and are almost giving away the roaming agreements to Google as price takers not price setters. This represents to me an historical acquiescence similar to the music industry caving in to Apple for $1.00 a tune, just to get on iTunes and find a marketplace, any market place for their music. Dumb Pipes I do not see this as a blockbuster for Google, no, rather as an omen of death for the carriers. Why? Because the network switches will be seamless meaning the customer will not know whether he is using Sprint's or T-Mobile's spectrum. It will move back and for the depending on signal strength. What that means is a validation of what I have written here, that Google has proven that the carriers are dumb pipes. Google will now deliver your content on somebody else’s fixed investment, and bypass the telco’s front office. You don’t even need to deal with them anymore. They are telling the investment community that these are commodity priced mules who haul other people’s content across and unprofitable and expensive to maintain, telecommunications infrastructure.

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US Peer Comps

The future of telcos … All these guys could go the way of Windstream (WIN US), a credible peer comp as recently as 2014, market capitalisation $527MM

US Telco Peers

Enterprise Ticker M-Cap YTD TTM PE 15 E PB 5Y CAGR Y SI D/E RSI

Verizon VZ US $194.09 B 1.70% -6.23% 11.92x 20.78x 7.65% 4.58% 3.92 921.05 47.55

AT&T T US $181.84 B 4.20% -3.21% 13.383 2.11x 4.06% 5.31% 8.71 95.02 51.70

BCE Inc BCS US $36.121 B -7.10% -6.39% 15.67 4.23x 5.07% 4.52% 10.61 220.27 45.95

T-Mobile TMUS US $30.83 B 41.20% 18.06% 20.94x 1.97x 10.00% 0.00% 5.83 156.29 53.22

Sprint Corp S US $15.23 B -7.50% -51.39% neg .52x 5.33% 0.00% 8.55 155.83 36.61

Frontier Communications FTR US $5.928 B -22.90% -11.38% 64.25x 1.47x 10.45% 7.78% 7.23 267.47 43.76

Telephone and Data Systems TDS US $3.12 B 14.50% 13.24% 37.303 .76x n/a 1.87% 1.91 50.82 50.83

US Cellular USM US $3.10 B -7.40% -7.38% 49.173 .89x 5.55% 0.00% 9.30 34.88 45.03

US Telco Peers

Enterprise M&A … who are you?

Verizon Bell Atlantic - GTE Merger

AT&T Bell Telephone - post break up took back Ameritek, Southwestern Bell and Pac Bell

BCE Inc Bell Canada

T-Mobile Deutsche Telecom

Sprint Corp Softbank 70% … GTE Nextel Clearwire

Frontier Communications Citizens Communications Company

Telephone and Data Systems worth nothing stripping out USM

US Cellular subsidiary of TDS 84%

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Other, brain damage

I would like to devote a future report to the subject of cellular radiation and brain damage. There is not further time today, but this remains a long-term risk multiple entrants in the telecom food chain.

Conclusion

The future for telecom carriers, wireless operators and ‘data mules’ is one that might be characterised by deteriorating core business fundamentals, shrinking earnings and falling share prices. This is because innovation giants have permanently changed the way we communicate. Similar to what has been detailed with streaming media and internet TV, new technologies give the consumer new ‘choices;’ which have evolved our behaviours, buying habits and preferences away from the old economy operators.

Long-term industry profitability has been marginalised by commodity pricing, which has ushered in a new era of value destructive, cash burning, price wars. Google’s Project Fi is just the latest illustration of the ‘dumb pipe’ conundrum facing the telcos. As long as the telecom carriers and mobile operators fail to innovate, they will be the faceless maintenance workers tasked with oiling, cleaning and upgrading the profitless network (Cloud hosting analogy).

Don’t let the P/E and the dividend scare you. Verizon is one bad quarter away from a house of cards. Investors are buying a 4% corporate bond with no maturity date, no return of principal and the real possibility of the dividend cut. On an asset basis the shares are grossly overvalued with P/B of 21x. The books are dangerously overleveraged, with total debt to common equity stands at 921% and $113 billion in debt.

The core business is haemorrhaging mobile subscribers and there is no credible growth strategy. Management is managing the company by walking tightrope, able to service $131B debt on $127B revenues. Razor’s edge, able to finance dividend with 90% pay out on $9.6 B in net income with $8.6 B paid out. Recommended Action Short Verizon (VZ US) In Play

Initiating the investment methodology with the top down global macro, I have been generating standalone equity shorts by first:

a) Searching for unfavourable themes and deteriorating fundamentals within sub-sectors of larger industry groups then,

b) Identifying economic trends within a space that may result in ‘opportunity’ characterised by 1) systemic flaws in core business model, 2) inability to adapt/evolve to changing marketplace and new technologies/entrants, and especially 3) meaningful risk to earnings expectations and finally,

c) Conducting research and analysis to detail unique securities; those within a peer group which best demonstrate essential elements of the bear case, the theme, the short story

Ultimately I am trying to produce one name, ‘the best constituent’ which displays the most attractive risk-reward profile for asset price depreciation of the comps. Visible patterns are developing and we can identify recurring tendencies delivered by this investment process. What’s on the menu?

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Television (network broadcasting and cable)

Traditional American television and cable has entered into a period of irreversible structural decline

Channel bundling, timetable line-ups and the advertising-driven revenue model are unsustainable

Aggregators and distributors of content (middlemen) will be marginalised in the age of internet streaming media and ‘New TV’

The broadcasters are not capable of competing with the technology giants who are redefining the industry, and carving up the business landscape in the new age in television

Margin compression, negative revisions, and earnings decline will accelerate, leading to industry rerating’s, and perhaps even obsolescence

CBS Corp (CBS US) quantified with financial analysis and enterprise-specific short rationale

Publishing (print media)

The publishing industry in long-term and irreversible state of terminal contraction

Newspapers the next ‘Yellow Pages’, magazines become ‘adzines‘, books devolve to ‘special purpose’ usage

Old economy publishers unable to evolve in the digital media world

New economy of digital media is being shaped by entrants with superior technology and innovation capabilities

Margin compression, negative revisions, and earnings decline will accelerate, leading to rerating and ultimately operating losses

News Corp (NWSA US) quantified with financial analysis and enterprise-specific short rationale Technology (File Sharing Platform)

Box Inc. (BOX US) is a second-tier entrant in the fundamentally unattractive and largely unprofitable technology niche of cloud-based file sharing (software architecture). The company does not appear to have any competitive advantages over the competition and has of yet been unable to distinguish itself in the largely commoditised cloud storage industry

With just 37MM users and only 47K paying customers, Box is a tethered goat in a forest of industry apex predators including Microsoft OneDrive, Google Drive, Amazon Zocalo, Citrix XenMobile, IBM and a phalanx of independents including Dropbox

The tech giants use file sharing as a loss leader to support well developed ecosystems, and thus crush the margins of participants like Box, whose core business is file sharing. Quite literally dozens of privately held start-ups offer file sharing technologies for free

The firm was unable to capitalise on initial first mover advantage during ten years of operations and with the arrival of powerful new market players, thus future profitability seems improbable (even to company IR colourists)

Following a much hyped public listing, Box shares have fallen 30% in six months and are making post-IPO lows. Lock up and quiet period ended 22 July and I would expect insider selling

The firm has been significantly lossmaking since founding ten years ago and has no viable path to positive cash flow, much less earnings in the next three years

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SGA + Capex +78% YoY, are greater than revenues. High revenue growth is slowing demonstrably, but cost structures are such that higher sales do nothing to improve the profitability results, rather they equate to greater losses

The company is running a 2015 operating margin of -81.25% and is expected to remain profoundly negative until 2018; after which date, in such an evolving, rapidly transforming industry, even the most astute industry expert would be loath to provide estimates

Box generated $100 MM in losses on the bottom line 2013 and the company in expected to lose more than that ($101 MM) in 2018. And between now and then, the forecast is even worse with -$179 MM 2015, -$182 MM in 2016, and -$147 MM in 2017

ROIC is >100% meaning the company burns $1.00 for every dollar invested … annually

Q1 2015 cash flows from operations delivered a >100% YoY loss of -$32.2M vs. -$15.6M Q1 2014 … with just $284MM in cash vs $40MM in debt, it appears that without a secondary offering (fool’s gold), bond issuance (sucker born every day), or strategic sale (of what?), Box may be insolvent by mid-2017

M&A buyout risk seems low as the only reported offer of $550MM represents a near -75% discount to current market cap

Wildcard: share price is significantly leveraged to ‘street’ perceptions and credibility of charismatic Chairman, CEO and co-founder. Post-IPO disappointment and losses for virtually anyone who bought since the first trade, suggests that the believers are losing their conviction. My expectation is that investors and backers will look back on this meteoric rise with twinges of embarrassment

Technology (Pioneer Harvest, early niche entrants subsumed) – two parts Infrastructure Architecture (Cloud hosting) – part 1

Dark Clouds, ‘Tut tut, it looks like rain’ Chicken Little

Core business increasingly uneconomical as technology leaders compress margins

Leasers of cloud real-estate removed from value chain

Cloud hosting requires heavy capex and m-cap to build occupancy

But occupancy as standalone business niche is not profitable

Parallels with internet backbone network builders and Vegas hotel room operator without a casino

Margin compression, negative revisions, and earnings decline will accelerate, leading to rerating perhaps marooned or eaten

Rackspace Hosting (RAX US) quantified w. financial analysis and enterprise-specific short rationale Internet Media (Streaming Music) – part 2

Highly developed technology ecosystems have added or are adding proprietary streaming music services to their existing platforms

Streaming music is literally being given away for free (ad based radio model) or to attract users to larger environments (door prize)

Similar to niche operators like online gaming, online dinner reservations, online travel, and online messengers, the standalone online music pioneers are too small to survive with their singular product offering

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But at the same time, high R&D is required to compete with the massive scale of Apple (AAPL), Google (GOOG) and others; accelerating losses and leading to rerating, obsolescence

Reminds of a mini-Netscape or mini-RealNetworks (Explorer or MediaPlayer bundled in Windows, Adobe gives away Flash for free … who is going to go out and buy Navigator or RealPlayer)?

Pandora Media (P US) quantified with financial analysis and enterprise-specific short rationale

Perhaps a takeout candidate for proprietary content or existing customer base? More work required to move forward, indicating high risk

Internet (Chinese niche freebies)

Deluge of unprofitable niche entrants, in high-flying Chinese internet space, unable monetise site users

Chit chat, video games, streaming music, photo share and friend making services given away for free

No mobile cash payment platforms

Unable to compete with large and highly developed ecosystems Alibaba (Baba), Baidu (BIDU) and Tencent (700 HK)

No earnings, untenable valuations, in the absence of white knights possibly left orphaned to die

Changyou.com (CYOU US) quantified with financial analysis and enterprise-specific short rationale Entertainment and Leisure (Macau Casino Operators)

‘If you build it, they will come’ Ray Kinsella, Iowa corn Farmer

Casino run rate already down -46% YoY to date

Flood of new capacity (rooms) does not equal to revenue expansion; rather it foretells of impending operating losses

Declining occupancy rates will free-fall on the surge on new property openings

Vacancies will further rise against the backdrop Beijing driven anti-corruption crackdown, smoking ban and heightened scrutiny

Transition to family-oriented sports, leisure and entertainment destination is doomed to fail impressively

Profitability outlook darkened by deteriorating demographics, falling real-estate, recession on the SAR, and significantly higher COGS driven by pay role inflation due to systematic labour shortage

Our model and sensitivity analysis of peer comps to headcount and occupancy assumption scenarios points to

Wynn Macau (1128 HK) quantified with financial analysis and enterprise-specific short rationale including possible dividend cut and delayed launch to miss 2016 Chinese Lunar New Year

9 July HSBC raised to buy, 6 July Credit Suisse “worst is over” relief rally wishful thinking; filling rooms with lower quality, non-gaming ‘overnighters’ and increasing guest visits by enabling visa-free travel for mainland ‘day trippers’ is not a solution, it is a validation of short analysis

John Winsell Davies is the Chief Investment Officer of Tano Singapore Advisors Pte Ltd. This is an original opinion piece which may not reflect the views of the Firm The opinions expressed here are his own Linked-In format does not allow for my charts, graphs, tables and illustrations. As such clarity and impact of original report has been marginalised. Original report available by e-mail Questions and comments; please write to me in Singapore j.winsell@bloomberg.net Skype ‘johnwinsell’