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Turkcell is Turkey's leading mobile phone operator. A three year long shareholder dispute has contributed to a severely depressed stock price. The company has accumulated a cash pile of around one third of its market capitalization. At $14, Turkcell offers a high margin of safety, little debt, strong profitability and growth in a defensive industry

I) Introduction: A defensive pick in a growing industry

After several years of rapid growth, the Turkish economy appears to be facing strong headwinds. As the Turkish growth model - which is heavily reliant on domestic consumption, exports and foreign capital inflows - comes under increasing strain, the outlook for the economy has lost the shine it once had just a few years ago.

Our search for a 'defensive' stock pick in this precarious macro environment has led us to a telecoms company: Turkcell (NYSE:TKC). Unlike most of its international peers the company is growing revenue by double digits, while the share price remains depressed from a long, drawn-out shareholder conflict.

As Turkey's largest mobile operator, Turkcell has been the centre of a shareholder dispute for nearly three years. As a result, the company has not paid a dividend since 2010. Since then, a cash pile of TRY 7bn ($ 3.6bn) has accumulated on a market capitalisation of around $12bn.

Turkcell is the market leader in Turkey and several regional neighbours and has experienced double-digit subscriber growth in recent years. Furthermore, the company has little debt (around $ 1.6bn) relative to assets - a ratio of 1x EBITDA that is the envy of most telecom companies.

As value investors, we are typically skeptical of capital-intensive industries such as the mobile telephony sector, given the risk of its assets absorbing the cash-flow rather than it finding its way to shareholders. However, Turkcell's large cash pile and comparatively low debt offers a wide margin of safety.

Finally: Although the company has been shunned by investors, it has continued to grow at a strong 11% (whereas most international telecom operators are losing revenues) and build up its cash reserves.

II) The Business

Turkcell is a successful mobile phone operator with 51.5% market share in Turkey. In 2012, the company had revenues of TRY 10.5bn ($5.8bn); Net Income stood at TRY 2.13bn ($1.14bn), and the company's market capitalization currently stands at TRY 24.6bn ($12.2bn).

The Turkish government has actively pursued trade in the region as a matter of state policy. Turkcell is among the main beneficiaries of this drive. The company operates in Belarus, Ukraine, Georgia, Azerbaijan, Kazakhstan, Moldova and Germany.

Through its network of subsidiaries, Turkcell counts an overall subscriber base of 69.2m - nearly twice its core domestic Turkish subscriber base (some of these international operations are in joint ventures - mainly with FINTUR in the Eurasian market).

These numbers make Turkcell the third largest mobile-phone operator in Europe.

Besides its traditional mobile business, Turkcell is expanding into television with "Turkcell TV", along with mobile services, fiber optic broadband and - importantly - into further development of its own lower priced smartphone and tablet devices called the T-Series.

A joint venture with Qualcomm initiated last year is aimed at capturing the large market demand for mobile broadband in the lower price segment. Its first phone the T40 is being released this September.

The significance of this strategy is underlined by the reality that Turkey's mobile phone penetration is around 89% (European avg. is 126%), and smartphone penetration is only 24% (compared with 66% in China).

This gives Turkcell substantial room for growth in the more lucrative mobile broadband market, as the middle class continues growing (although perhaps at a lower rate than in recent years) and customers upgrade from pre-paid to more profitable post-paid subscriptions.

Turkcell - with its own cheaper smartphone - will be in a strong position to ride this development.

The company is geared for growth. Revenues increased 11% year on year to the recent quarter with growth particularly strong in mobile broadband (+44%), and among Turkcell's subsidiaries (+33%) in Eurasia.

This is primarily driven by the long term switch to more valuable smartphones in developing countries. A 'modern' mobile phone is often the first affordable and highly desirable consumer product coveted among emerging middle classes.

This trend stands in contrast to more anemic growth in the traditional voice business, where all operators are competing intensely on price per minute.

III) Competitive Advantage

Barriers to entry in the telecommunications industry are naturally very high - a result of the large capital expenditure needed to provide mobile services.

The core Turkish market is dominated by three players: Vodafone, Aveo and Turkcell. They - like anywhere - mostly compete on price for subscribers.

The Turkish government regulates the maximum price operators can charge per minute, with the result that the bulk of net earnings in the industry mostly derives from mobile broadband and other services.

Here Turkcell does well through its high quality network (i.e. the fewest reception and connectivity issues), top rated customer care and its mobile broadband services.

However, intense price competition by Vodafone and Aveo has hurt Turkcell's margins in the pre-paid segment.

Despite this intense competition, Turkcell's market position has only marginally declined from 56% in 2008 to 51.5% today. This speaks to the better network, valued customer care and superior product range that Turkcell offers.

Nevertheless, the company operates in a highly competitive market, an adverse regulatory environment whose board is paralyzed by an ownership battle and requires large capital expenditure to maintain and grow its customer base.

IV) Balance Sheet

Turkcell's balance sheet is in healthy condition, which is one of the main reasons the stock is appealing to us at current prices. Total debt has decreased from TRY 3.1bn in 2012 to 3bn now; meanwhile, the company has amassed more than TRY 7bn ($3.6bn) in net cash.

While the company has a track record of prudence in allocating capital, poor corporate decisions are always a risk.

V) Profitability

Although Turkcell has been taking a small beating in overall market leadership, it has been able to deliver better margins than its competition.

With on average a 10% higher EBITDA margin than both competitors, Turkcell earns around 2.5 TRY per minute more than its closest rivals. This is primarily due to Turkcell's stronger position among post-paid and data package customers.

The current EBITDA margin stands at 30%, which has contributed to Turkcell's strong cash generation.

In the most recent quarter, the company has produced TRY 558m of Net Income on TRY 2.8bn of revenues. This gives it a very healthy net margin of 19.8% (inching down by 1% from Q1 2013).

However - as pointed out before - Turkcell operates in a very capital intensive industry. This requires that the company spend heavily to maintain and expand its infrastructure. As it operates in many geographically difficult (ie. mountainous and arid) regions, its costs are even higher than other telecom companies.

Further, Turkcell is growing both organically and through acquisitions in the region, which only increases capex needs.

VI) Management

In the case of Turkcell, management has demonstrated both competence and prudence. However the management appears to be a bargaining chip in a three-way ownership battle between the Swedish Teliasonera, the Russian Alfa Group and Cukorova of co-founder Mehmet Karamehmet.

In addition to blocking many important non-operational decisions, this boardroom struggle has prevented Turkcell from holding a general meeting and from issuing a dividend since 2010.

Karamehmet has won a recent decision by the UK Privy council, which allows him re-acquire a stake from Alfa Group for $ 1.56bn - almost half the amount Alfa Group claimed Karamehmet owed it after he had defaulted on a loan in 2007.

Although the $ 1.56bn only amounts to 13.8% of Turkcell's shares, they will give Karamehmet's Cukurova control over the company. This is due to a complex ownership structure that sadly disregards the rights of small shareholders.

It appears now that Cukorova had support from the Turkish authorities, which favored a deal that would keep control of Turkcell in local hands.

On the other hand, Karamehmet himself is under heavy scrutiny by Turkish authorities in a dispute related to the 2001 Turkish banking crisis. A court had originally sentenced him to several years in prison for fraud and assets of his have been seized. Additionally, a US court has ordered Karamehmet's Cukorova to pay nearly a billion dollars to Teliasonera in a separate award and has ordered the seizure of his US assets.

Whether Karamehmet can come up with the $ 1.58bn to pay Alfa Group is thus open to debate.

This boardroom tussle has made the government intervene and appoint independent members, as the main shareholders failed to agree on any candidates.

Rather amazingly - and despite this corporate mayhem - the operations and expansion of the company have continued smoothly. The impact has primarily been felt in the valuation of the company.

VII) Two Catalysts

The most obvious catalyst for unlocking value in Turkcell is a final settlement of the board struggle. It currently appears that there is some movement on the issue - with a UK privy council making some inroads, but nothing is concrete yet.

If the company can settle on a dividend payment the stock will most likely rally, as three years in dividends will amount to maybe a TRY 5bn - 6bn distribution (10-20% of its market cap).

VIII) Risks

Competition in the Turkish market is fierce and both Vodafone and Aveo compete heavily on price. If the company doesn't keep its operational costs in place and misjudges its marketing or strategy, the competition is likely to absorb disappointed customers.

Regulation has also been a burden for Turkcell. The government caps the amount operators can charge per minute. This - in connection with tight price competition - squeezes margins. But then again, Turkcell mainly makes its money in more premium data bundles: overall, 30% of customers deliver more than 60% of revenues.

To highlight foreign operations risks to this investment idea: Turkcell has considerable operations in Belarus - probably the most autocratic and economically unstable countries in Europe. A balance of payments crisis made the government devalue its currency twice in 2010, which brought inflation to over 100%.

This Belarussian drama resulted in FX loss for Turkcell in the range of TRY 800m and decreased net income by maybe half a billion TRY.

Another red flag is that most of Turkcell's debt is denominated in USD, while the company earns most of its money in Turkish Lira as well as other more volatile currencies. Although Turkcell's overall leverage is low and its cash position comfortably covers its debts by a ratio of 4:1, the fact that most of this debt is USD denominated exposes TKC to currency fluctuations. The Turkish Lira has already seen a 40% devaluation since 2008 because of the general economic slowdown.

If things deteriorate considerably more on the macro side, Turkcell may be exposed to growing debt and shrinking debt servicing capacities (however, earnings in Belarus and Ukraine are effectively in dollars as their currencies are fixed).

Overall, the ownership 'paralysis' is the greatest risk to Turkcell. The main owners have been engaged in infighting for over three years now. The worst-case scenario is that this continues for many more years and minority shareholders get trampled even more.

The final risk is a more assertive Turkish government, which undoubtedly hopes to exercise more control over one of its national champions.

This is further evident in the AKP's more authoritarian streak and how it prefers the largest telecoms company not also fall completely into foreign hands. This might bring up a certain risk of a new large Turkish investor.

IX) Why is Turkcell cheap?

Source: Yahoo Finance

The obvious reason is the boardroom war the company has been ensnared in for years. No dividends for three years scared off many investors.

Secondly, Turkish equity markets are down significantly as a result of street protests in Istanbul and Ankara since May/June of this year. There is a threat of a further escalation as the AKP refuses to reach out to the demonstrators and the opposition and presents itself as increasingly authoritarian.

This is reflected by a 20% drop in the Turkish stock index since the protests began.

Source: Bloomberg

Finally, the Turkish economy has slowed down considerably since its boom years leading up to 2008. The Turkish lira has depreciated by more than 40% to the EUR since its peak - which has taken a toll on equity prices (See chart below)

Source: Yahoo Finance

Market timing is a treacherous affair - and best to steer clear of in our view. Although in the short term TKC may depreciate more, we strongly believe that Turkcell at a sub $14 price qualifies as a bargain.

As a result we also find it noteworthy that legendary value investor Howard Marks of Oaktree took a stake in the company, as well John Rogers of Ariel Capital Management.

X) Valuation

Turkcell has about $4 of cash per share on its books - the result of not paying a dividend for the third year running. As value-focused, long-term oriented investors, we don't mind seeing this cash pile grow by its 10% per year.

It is almost inevitable that this cash will find its way to shareholders in the form of a special dividend and/or higher future dividends.

With earnings of $1.34 per share, the company trades at a PE of only 10.5. This is particularly low, considering the potential dividend yield of around 5.5% and comparing it to Vodafone's PE of 19. This of course ignores the cash on its balance sheet. Minus the cash, the PE ratio gets closer to around 7 - 8. That is very cheap for an emerging markets blue chip.

Furthermore its price to cash-flow per share ratio stands at less than 7. Combine that with tangible book value of $7 per share.

In a nutshell: We estimate Turkcell's intrinsic value at closer to $21 than the current $14, giving the stock some 50% on the upside. Turkcell is defensive Turkish blue chip with a track record of growth and a healthy margin of safety - all at a very reasonable price.

We always encourage everybody to do their own due diligence and welcome any feedback!

Source: Digging Deeper At Turkcell