Enthusiasm Over SK Telecom Has Gone Far Enough

By Stephen D. Simpson, CFA | June 18, 2013 AAA

Investors don't love telecom service providers like they used to, largely due to extreme competition that has made it difficult to grow revenue or improve margins, all the while spending billions on equipment to keep the network current. It's arguably worse in the case of SK Telecom (NYSE:SKM), as management here has made it clear that they believe they're able to do more than just run a telecom business and have deployed billions of dollars in questionable non-telecom investments. While the sharp run-up over the past year was largely reasonable, as it brought SK Telecom back into parity with many of its global peers, it's hard to argue that these shares deserve to go much higher.

LTE Is Great, But How Much Further Can It Go?
SK Telecom has been very good at signing up subscribers for its LTE service – at nearly 10 million subs, SK Telecom has the fourth-largest LTE business in the world. With LTE average revenue per user (ARPU) more than 40% above the company's blended average, that's a very valuable business.

SEE: How To Pick The Best Telecom Stocks

The question I have is whether this can go much higher. SK Telecom's primary rivals, KT Corp (NYSE:KT) and LG U+, have stepped up their game as well and competition for subs in South Korea in the past has been notoriously brutal if not economically irresponsible. With SK Telecom's ARPU up 4% in the most recent quarter (and down slightly on a sequential basis), I think it's fair to argue that business has more or less settled into a steady state for now.

Focusing On Keeping What It Has
SK Telecom's market share has been around 50% to 51% for some time now, despite the aforementioned fierce competition. It's unlikely that the company is going to significantly expand that, and so management has been focused on increasing retention and reducing subscriber acquisition costs. The company has been introducing plans that give monthly data “refills” based on how long of a contract the subscriber signs, and has likewise been trying to cut its marketing costs. Even so, first quarter operating income fell 18% and 24%, respectively, so there's more work left to do.

Iffy Capital Deployment Decisions
Even with the high ongoing capital investment requirements of a mobile network, telecom service providers generate pretty solid cash flows. Unfortunately, SK Telecom management's record of redeploying that cash is spotty at best.

At one point, SK Telecom did have a go at becoming an international player, but most of those ventures didn't work out so well. A joint venture with China Unicom (NYSE:CHU) worked well enough I suppose, but SK Telecom long ago sold back its stake. The company's business in Vietnam didn't go nearly as well (and the company bailed a while ago), and the venture in Mongolia has pretty unimpressive market share (below 15%).

Those are veritable success stories compared to the company's experience in the U.S. The Helio venture was nearly a 75% loss, while the $60 million investment into now-bankrupt LightSquared is likely to be a major loss as well. Moreover, given the moves from Verizon (NYSE:VZ), AT&T (NYSE:T), T-Mobile, and Sprint (NYSE:S) – Softbank, I don't see all that much room left in the U.S. market if they wished to try again.

With such a poor track record in telecom investments, perhaps I shouldn't be surprised that management elected to buy a large stake in SK Hynix – a major manufacturer of DRAM and flash chips. While Hynix is a relatively good player in the memory space (good enough, at least, that Apple (Nasdaq:AAPL) uses its chips), this is an exceptionally volatile business and one with high ongoing capital requirements.

The Bottom Line
In essence, I see SK Telecom as a telecom service provider competing in a difficult market (South Korea) where government-mandated price cuts and often-irrational competition will offer consistent pressure on ARPU, churn, and profitability. Moreover, the company is led by a management team that would seemingly prefer to take the cash flow and invest in questionable directions rather than return it to shareholders.

SK Telecom has historically converted more than 10% of revenue to free cash flow (and sometimes more than 16%), and that underpins the value here. While the big move in the stock has brought the shares back to a fair valuation level, I don't see why the move should go much further. Even with consistent low-teens free cash flow margins, I don't see fair value much above $22 today.

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