Blue Label’s share price has been on a strong run since it announced its intention to invest a 35% equity stake in Cell C at the end of last year. Coupled with good growth numbers in its first half 2016 results, it has gained more than 60% so far this year. With a relatively high earnings multiple of 23, against a backdrop of lukewarm sector prospects and Cell C’s idiosyncratic challenges, we are downbeat on the counter. We think it is time for investors to take profits. We change our recommendation to “sell” from “hold”.

We understand that Cell C has significant debt, has poor network quality and needs substantial investments so that it can support additional subscriber growth. As such, we presume that value from the transaction will accrue only in the medium term after Cell C has been properly recapitalised. However, this is not to say that other synergies will not accrue much sooner, given the symbiotic nature of the two companies. But our overall opinion is that Cell C needs a substantial capital injection to make it competitive both financially and operationally, which will have an adverse effect on Blue Label’s free cash flows in the short term. Our discounted cash flow model also suggests the counter is overpriced, but the Cell C deal hype might create share price support.

Furthermore, the telecommunications sector is in a structural slowdown, where customers are getting more value for less, and the trend is set to continue. Blue Label CEO Brett Levy also says it will be difficult for Blue Label to repeat its recent double-digit growth numbers, which were due to the expansion of its distribution channel. He expects growth of its biggest revenue contributor, prepaid airtime, to fall back into single digits of between 6% and 9%.

There are some positive factors for the business.

First, Blue Label is positioning itself to meet the increasing demand for low-cost smartphones and tablets through its existing distribution network in and outside South Africa.

Second, the addition of electricity to its array of products, which enables prepaid electricity and other purchases at points of sale at distributing retailers as well as vending machines, diversifies its reliance on prepaid airtime. In that vein, distribution of prepaid electricity is expected to grow substantially in the short to medium term as government rolls out additional prepaid electricity meters. Prepaid water is also expected to gain traction.

Third, its initiatives in Mexico should continue reducing losses as restructuring takes effect.

Fourth, marketing efforts in India are expected to grow transactional revenue from its wallet subscriber base, a money transfer product. However, it is worth noting that all Blue Label’s foreign operations are loss making and as such growth will be off a low base.

Cell-C-640 — Cell C needs a substantial capital injection to make it competitive both financially and operationally, says the writer

Additionally, the group is positioning itself to supply low-cost smartphones, which management says have shorter lifecycles and could potentially create recurring sales. This initiative should be supported by the launch of 400 retail technology stores in the short to medium term in a joint venture with the Edcon group, dubbed Edcon Connect stores.

Our valuation model, based on the company’s operations excluding the potential Cell C deal, shows that the counter is overpriced and investors could take profits. We believe that Cell C will require an additional capital injection in the short term, which will reduce the group’s free cash flows. It does seem like Blue Label is one of the few bright spots in the telecoms sector, but its valuation is stretched and we are bearish on its short-term performance.

Performance review

The performance for the year to end-May was underpinned by expansion of product distribution channels, which resulted in market share gains. South African revenue grew 19% to R25,7bn, but earnings before interest, tax, depreciation and amortisation (Ebitda) rose only 9% to R1,1bn because some of the margin was invested in expanding the distribution channel. As such, the Ebitda margin declined to 6,15% from 6,67%.

As Mexico cut its losses by 28% to R63m, the Indian subsidiary registered a loss of R27,7m, as significant costs were incurred to expand its mobile wallet subscriber base. The losses incurred internationally took 13,66c/share off headline earnings. However, the overall decline in net interest charges bolstered headline earnings, which rose 22% to 100,4c/share.

A dividend of 36c/share (FY15: 31c) was declared.