Telmex's Telling Transformation

Telmex (TMX Quote) at 100? That price may not be as loco as it looks.

Mexico's dominant telecommunications company, which closed Tuesday at 62 1/4, already is up a hefty 28% this year. But it could soon approach a triple-digit price tag, according to some investors and analysts.

Telmex is making a remarkable yet underappreciated transformation from stolid utility to burgeoning growth stock, these people say. Additional support could come from Mexico's economy, which is healthier than it's been in decades.

"It could be a $100 stock in 12 months' time -- easily," says Calum Graham, a portfolio manager on the (GIEMX Quote)Govett Emerging Markets fund. "Telmex is still being priced as a boring fixed-line utility when it's becoming a growth telco." Graham has around 5% of his fund in Telmex.

Luiz Carvalho, Latin telco analyst at Morgan Stanley Dean Witter, points out that Telmex's share price implies investors are paying $2,600 per phone line, while European companies facing considerably slower line growth trade at around $3,500 per line.

So if Telmex simply began trading on European-level asset valuations, it would rise to near 100. "That's not unreasonable," says Carvalho, although he believes such a run-up is unlikely in the next 12 months and would happen only if investors come pouring back to Latin America. Carvalho's firm has not done any recent underwriting for Telmex.

After five difficult years, Telmex has emerged well positioned to move beyond its core business: fixed-line telephony, which was the source of just under 85% of revenue in 1998. The masterminds of these maneuvers into new territories are Chairman Carlos Slim Helu, the billionaire Mexican who controls Telmex, and Slim's sons, Carlos Jr. and Patrick, as well as a management team led by Chief Executive Jaime Chico Pardo.

Telmex's cellular subsidiary Telcel, which accounts for 10% of revenue, is growing at a torrid pace, and could, according to Morgan Stanley's Carvalho, contribute 22% of revenue by 2000.

Subscribers rose 90% in 1998 and Telcel's cash-flow (earnings before interest, taxes, depreciation and amortization) margin surged to 38% from 14%. Most important, the company has achieved strong growth without taking on low-paying customers: Average monthly revenue per subscriber slipped only slightly in the fourth quarter to $45 from $50 a year earlier, pleasantly surprising analysts who had forecast a steeper drop.

Elsewhere, sales at Telmex's data and network business, accounting for some 5% of revenue, have tripled over three years. Shares in Prodigy (PRGY Quote), the U.S. Internet provider in which Telmex holds a 21% stake, have soared 167% since their February IPO.

Earnings per ADR for Telmex rose to $4.25 in 1998 from $3.72 the previous year. The First Call consensus calls for a rise this year to $4.73, which would give the company a price-to-earnings ratio of 13.2.

Also firing the imagination of Telmex bulls is the prospect of Telmex expanding into the U.S. to gain a slice of the Hispanic-American market. Patrick Grenham, Latin telco analyst at BBV Securities, thinks Telmex's finances will be strong enough by 2002 to fund an aggressive push in the U.S., perhaps through an acquisition. BBV has not done any recent investment banking work for Telmex.

In addition, Telmex has the reassuring advantage of huge cash generation from its traditional activities. Last year, the company churned out $4.5 billion of cash on an EBITDA basis and earned $1.69 billion. This gives the company the clout to continue funding a giant stock buyback program under which it has repurchased 2.8 billion shares since 1995, reducing shares outstanding to around 7.5 billion.

And it's possible that the buyback program could pick up pace. Due to scheduled changes in Mexican ownership rules, Slim, through his holding company, Carso Global Telecom, needs to boost his stake in Telmex to 25.5% from the current 21.6% by 2001 to retain control. The cheapest and most advantageous way for Slim to achieve this is to reduce Telmex's shares outstanding, increasing Carso Global's ownership percentage. To obtain the all-important 25.5% share, the company would need to buy back another 1.01 billion shares by 2001, which would provide a nice cushion under the stock.

What's more, if Mexico manages to cut interest rates still further, Telmex could take off more quickly than many expect. If inflation stays dulled, then interest rates, currently at 22%, could be cut to below the psychologically important 20% mark. If that happens, "Telmex could even hit $100 in six months," says Govett's Graham.

But of course Mexico is, well, Mexico, where nothing goes according to plan.

First off, if Telmex continues to rise, some investors and analysts say the stock would begin to look pricey. "From a valuation point of view, Telmex is beginning to look a bit stretched," says Warren Howe, manager of the BT Investment (BTLAX Quote)Latin America fund. Even at 100, Telmex would boast a 1999 P/E of 21, considerably cheaper than P/Es for European telecoms, which trade between 23 and 26 times current earnings.

But investors rightly demand that stocks be cheaper in countries like Mexico to reflect the greater risks. For example, Mexico has its presidential election next year. The run-up to the last presidential contest, in 1994, was marred by two destabilizing political assassinations. The government also set the stage for the disastrous 1994 peso devaluation by secretively pumping money into the economy and running down hard-currency reserves to almost zero.

The country's economic data are much more transparent now, and the International Monetary Fund and the U.S. Treasury Department now closely monitor economic developments south of the Rio Grande. In addition, the 1997 local and congressional elections, which included the contest for the massively influential mayoralty of Mexico City, passed uneventfully.

Another worry: Competition is scheduled to begin this year in the local and cellular markets. This in itself is not likely to seriously challenge Telmex, which has limited losses in long-distance market to competitors like AT&T (T Quote)-owned Alestra and MCI WorldCom (WCOM Quote)-owned Avantel. That said, if Avantel and Alestra were to merge, then it could be time for Telmex to start worrying.

But for now, fans figure everything that's making Telmex a growth stock will enable it to overcome these entanglements.