SIF Folio: Airtel Africa promises emerging market growth

African telecoms and mobile money operator Airtel Africa is a stock I’ve been watching as a possible income play for much of the last year. So I’m interested to see this stock now qualifies for my SIF buying screen. In this week’s piece, I plan to take a closer look at this business.

SIF does not currently have any exposure to the telecoms sector. Although this sector has a history of capital destruction, I think the African market in particular is attractive due to the parallel growth of mobile money services.

Airtel Africa (LON:AAF)

Airtel Africa floated on the London market in June 2019, when it was spun out of Indian group Bharti Airtel. Only 19% of the company’s stock was sold in the IPO and the former parent remains a controlling shareholder, via (I assume) the top two holdings listed in Stockopedia’s shareholder data:

The group operates in 14 countries in Africa, mainly East, Central and West Africa. It’s the second-largest mobile operator in Africa and is first or second by market share in 12 of the countries in which it operates. Nigeria is by far the largest market and generated 40% of revenue and 45% of EBITDA last year.

Customer numbers across the group rose by 6.9% to 118.2m during the year to 31 March, while the number of data customers rose by 14.5% to 40.6m. The number of active mobile money users rose by 18.5% to 21.7m. 

These metrics translated into a pre-tax profit of $697m, 16.7% higher than in FY20.

I think that the big stories here are the growth potential of the African market and the value of the mobile money business. The other attraction, in my view, is that the company isn’t burdened with legacy assets and regulatory obligations (BT) or sluggish mature markets (BT and Vodafone).

In the short term, my main concerns are corporate governance and political stability in Africa, especially Nigeria. Longer term, what worries me is that Airtel could become too much like Vodafone.

However, that’s all for the future. Right now, what matters for me is to understand how Airtel Africa’s numbers shape up against my SIF buying rules.

The initial omens are promising. Airtel scores a StockRank of 96 and Super Stock status.

As usual, what I’ll do now is to break down the company’s QVM factor scores to understand more about Airtel Africa’s valuation, profitability and outlook.

Value: a cash cow?

Airtel’s ValueRank of 91 is its strongest factor score. The firm’s valuation metrics show some promising numbers:

Cash generation improved last year, but the business is still modestly valued relative to its free cash flow. 

When one of these ratios shows n/a, it means the denominator is negative. So in this case, Airtel Africa’s tangible book value is negative. The balance sheet shows us why. Goodwill stood at $3,835m at the end of March, compared with physical assets of just $2,066m.

This situation suggests to me that the company has been constructed through a series of acquisitions or corporate transactions. These have been priced at levels to reflect future growth potential - hence significantly above tangible net asset value.

There’s not necessarily anything wrong with this, but it will take some years for us to learn whether management’s judgement was correct. 

Interestingly, I note that the company uses 10-year projections to test for goodwill impairment, rather than the more usual five years. Airtel says this better reflects the expected life of its network assets and the growth potential of the African market. Again, in principle this seems reasonable to me. But in practice I think there’s a risk that it provides significant wiggle room to mask short-term underperformance.

Even so, Airtel Africa’s valuation looks favourable to me, based on two of the other core metrics used in the ValueRank calculation:

• Earnings yield (EBIT/EV): 15.6%

• Dividend yield (trailing): 3.6%

The group’s net debt rose by around 8% last year to $3,530m, giving a net debt/EBITDA ratio of 2.0x. This is at the upper end of what I’m comfortable with for an emerging markets business. But I wouldn’t rule out the stock on this account, given the company’s strong free cash flow, improving performance and attractive profit margins.

Quality: strong profitability

Airtel Africa is one of the most profitable network operators among UK-listed telecoms stocks. Although the QualityRank of 71 is the stock’s lowest factor score, I don’t see any obvious cause for concern. 

The group’s operating profit margin and return on capital employed have been high and improving since its 2019 flotation (I would disregard the pro-forma numbers from before the IPO, as they are likely to reflect a different corporate structure):

Airtel also boasts a strong Piotroski F-Score of 7/9. This fundamental health check tests whether factors such as cash generation and profitability are improving. The F-Score is an major part of the QualityRank calculation and I find it provides a useful snapshot:

Why is Airtel Africa so much more profitable than Vodafone, for example? After all, Vodafone also operates mobile networks and a mobile money business in Africa. 

I’m not entirely sure why Airtel has such an advantage, but I would guess that much of the advantage is due to the group’s sole focus on Africa. According to the company, most African countries only have two or three mobile operators. In western Europe, there are usually more, especially when low-cost virtual operators are included. I’d guess that margins are higher in Africa and that regulatory price controls may be less onerous.

The other factor driving the improvement in Airtel Africa’s profitability is most likely to be its strong growth rate. European operators can’t match this, but can Airtel maintain its momentum?

Momentum: improving?

Airtel Africa’s MomentumRank of 82 is healthy enough, but it’s worth noting that this figure has risen by 44 over the last 30 trading days:

What lies behind this sudden increase? To find out more, I’ll look at the two components of momentum separately.

Earnings estimates: The change in MomentumRank coincides with the publication of the company’s final results, which were released on 12 May. The results appear to have triggered a round of broker upgrades, the second such increase in three months:

Price momentum: Airtel’s share price has not made much progress this year, although it is significantly ahead of last year. However, two key price momentum metrics I check for are showing green at the moment:

The 1y relative strength shows that the stock has outperformed the market by a big margin over the last year. This is one test used by my screening rules to avoid turnarounds and other special situations.

The 10d/3m volume indicator shows that buying levels have been higher over the last 10 days than the average over the last three months. This also seems to support my theory that market sentiment has improved since the company’s results were published.

On balance, I think the near-term outlook is improving for Airtel Africa. Given the stock’s attractive forecast valuation metrics, I believe there might be an opportunity here:

My decision

In my working life, mobile network operators such as Vodafone have become known for their ability to destroy shareholder value. They must constantly invest in mature, competitive markets. In some cases, including Vodafone, this has driven returns below the cost of capital. 

My fear is that Airtel Africa may eventually be destined for the same fate, but as yet I think we’re still a long way from this scenario. 

Based on the group’s performance since joining the London market, I can see quite a lot to like about Airtel Africa. The stock’s valuation seems reasonable and the company has delivered strong growth in recent years. The outlook also seems positive.

Airtel Africa passes all of my screening tests and should add to the diversification of the SIF folio. For these reasons, I’ll be adding the shares to SIF this week, and to my own holdings. As always, I’ll make these trades after this article has been published.