TKC - Turkcell Continues To Execute Well But Macro Remains An Uncontrollable Risk

Summary

• Turkcell management has continued to deliver strong performances in challenging times, with ongoing subscriber growth and not as much EBITDA margin erosion as feared.
• Significant capex spending on the mobile network is still in the future, and the company continues to invest in the growth of the fiber broadband business today.
• Capex investments may disappoint some investors who prize dividends in the short term, but they are sound reinvestments in the future growth and competitiveness of the business.
• Valuing Turkcell is exceptionally difficult given the macro environment, but long-term revenue growth of around 10% and mid-teens FCF margins can support a double-digit long-term return today.

I believe I’ve been fair, if not effusive, in my praise of Turkcell ( TKC ) management, and nothing has changed since my last article on this leading Turkish telecom provider to change my view. Management continues to do a good job of navigating a difficult inflationary environment (running at around 85%/year), as well as keeping the company ahead of rivals and continuing to reinvest in the long-term growth potential of the business.

While I thought the challenging macro environment in Turkey would mitigate potential gains in the share price, I’m happy to say I was wrong – Turkcell shares have risen more than a quarter since my last update, a strong performance against a backdrop of largely negative emerging market telco performances over that time. While the shares still look undervalued, the challenges of modeling in a high-inflation environment are considerable and ongoing erosion in the value of the Turkish lira remains a real risk.

Continuing To Log Solid Results

Turkcell has established a credible reputation for beat-and-raise performance, with management being conservative enough on guidance to give themselves some room to maneuver, but not undermining the point of the exercise with low-ball numbers. Moreover, given the ongoing challenges in the Turkish market from high inflation and the company’s ongoing growth strategies, I think the outperformance is a little more impressive.

Turkcell’s last quarter saw the company post 57% revenue growth, with 57% growth in the core Turkish operations and nearly 80% growth in the much smaller International and Techfin segments. Growth in Turkey was driven by inflation-fueled price action, with blended mobile ARPU up almost 49% and fiber ARPU up more than 26%, but Turkcell also continues to benefit from an ongoing shift to more lucrative post-paid plans, increased subscriber counts (and lower churn), and greater use of data and digital services.

EBITDA rose 49% in the third quarter, with margin declining 220bp to 40.9%. Profitability was helped by stronger results from the Ukrainian operations (a nearly 60% EBITDA margin), while core Turkish operational EBITDA rose about 44%, with margin down four points to 43%. There’s nothing particularly surprising as far as the drivers of weaker margins – while Turkcell is being quite active on pricing, there’s only so far they can push consumers and the company continues to absorb higher wage and operating costs (utilities, et al).

With third quarter results in hand, management once again raised guidance, hiking the revenue target by 5%, with a similar increase in the EBITDA target.

Ongoing Reinvestment To Drive Further Growth

Circumstances in Turkey have delayed 5G buildouts, but Turkcell nevertheless continues to invest meaningful sums in both its mobile and fixed broadband infrastructure, with operating capex to sales of about 17% in the third quarter.

Turkcell will ultimately have to lay out meaningful sums for a 5G upgrade cycle, and that is likely to drive capital intensity in the mobile business above its recent trend rate of around 7%. Turkcell has prospered on the back of offering superior network quality relative to its main rivals Vodafone ( VOD ) and Turk Telekom ( TRKNY ), and Turkcell enjoys a higher mid-to-high-40%’s market share among higher-value postpaid and “4.5G” subscribers.

As network quality has been a major competitive differentiator for the company, I expect meaningful spending on 5G to maintain (if not build upon) that advantage. I’d also note that about half of Turkey’s population is young (below the age of 33), and over 20% of the population is younger than 14. As these people age, their mobile usage and data consumption is going to increase, and Turkcell is going to need to invest in capacity simply to keep up with growth in data traffic.

In the meantime, the company continues to spend considerable sums to build out its fiber infrastructure and related offerings. Management has increased the number of homes passed by fiber to 5.25M from around 3.8M near the end of 2020, and I expect an ongoing multiyear investment push.

Fiber penetration is still lower in Turkey than most European peer countries, with correspondingly lower internet speeds, and I believe this is a lucrative long-term opportunity. Beyond basic fiber service subscriptions, Turkcell has executed well with its service attach rate, with around 1.2M IPTV subs against a roughly 3.4M combined fiber/xDSL subscriber count, and the company continues to add over-the-top service offerings in addition to a range of internet-based offerings (including its Turkish-language search engine Yaani and its Bip instant messaging service).

The Outlook

High inflation adds more challenges to the modeling exercise. I don’t think 40%-plus ARPU growth is sustainable, and I don’t see how the country can withstand 85% inflation rates (and supposedly the “real” rate of inflation is even higher, with government officials reported pressured to report lower figures), as there are reports that many Turkish citizens are already struggling to make ends meet. Unfortunately, the country is run by someone who believes that the way to combat inflation is by cutting interest rates (the exact opposite of what pretty much every other central bank in the world does), so it may take a full-blown crisis to drive real change.

So, whether or not Turkey sees a full-blown financial crisis, at some point this spiral has to stop and prices have to cool. I still expect Turkcell to generate long-term revenue growth in the neighborhood of 10%, driven by population/subscriber growth, increased use of higher-value services, and price increases, but modeling that eventual cooldown is entirely arbitrary. Likewise with capex spending – Turkcell has spent less than I expected over the last 18 months, but I don’t see the ultimate need to spend more on capex going away. I believe long-term FCF margins will average out in the low-to-mid-teens, but here again there is considerable modeling uncertainty.

Discounted cash flow suggests that the shares could still be at least 20% undervalued and priced for a long-term total annualized return in the mid-teens. Unfortunately, for all of the faults and challenges of free cash flow modeling today, a multiples-based approach is no easier.

Historically you can assign fair multiples to emerging-market telcos on the basis of attributes like ROE or ROIC, but the macro issues in Turkey argue for at least some modification. So while Turkcell may deserve a fair value 50% above today’s price (if not more), the operating environment is clearly driving a sharp discount.

The Bottom Line

I’m typically a big believer in the idea that investors won’t go too far wrong investing with good management teams, and I think Turkcell has a good one. But in the “rock, paper, scissors” of management, macro, and secular growth drivers, macro can have a disproportionate impact. I do still see a path to better days (which is why I still hang on to my small position in TKC shares), but investors need to be well aware of the macro challenges and have an exceedingly high level of patience (or pain threshold) to pursue those potential long-term gains.

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