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Questioning Rain’s valuation

Two facts provide much-needed context.
Telcos need to keep spending vast amounts of capex just to stay in the game, so can 5G capex really be excluded from Rain’s performance, cash flows and profits? Image: Bloomberg

African Rainbow Capital (ARC) reported its full year results for 2021 (FY21) last week. The group reported a 16.3% rise in its so-called intrinsic portfolio value to R12.3 billion, albeit that once the recent dilutive capital raise is excluded the group saw its intrinsic net asset value (INAV) fall 8.1% year on year.

Plenty has been written about this holding company’s expensive external management company and the fees it charges, so I won’t revisit this other than to suggest that investors looking for an appropriate discount for this holding company do the math.…

What I want to focus on is its investment in Rain, the young and fast-growing data-only telecommunications start-up.

Firstly, it is great to see this telco hitting its targets.

Significantly helped by lockdown-induced consumer demand for data for remote-working, gaming and the like, Rain appears to be performing really well.

I say ‘appears’ because we know very little about it. No separate numbers or even subscriber stats are released.

In ARC’s presentation on its results, management did reference that it is Ebitda (earnings before interest, tax, depreciation and amortisation) positive and, in the absence of the cost of the 5G rollout, would be doing much better.

But that is the nature of telcos: you have to keep spending vast amounts of capex just to stay in the game. Can we really exclude 5G capex from Rain’s performance, cash flows and profits, or is it just the cost of keeping a seat at the telcos table? Is it really ‘expansionary’ capex if you need to spend to remain relevant?

Secondly, ARC wrote up Rain’s fair value in its INAV and the telco remains its largest single exposure: in the region of a whopping 27% its portfolio.

Source: African Rainbow Capital

This large weighting of Rain in ARC’s portfolio makes the lack of detailed disclosure even more bizarre and frustrating.

So how reasonable is ARC’s valuation of Rain?

Well, we have no idea – we just have to trust management – but I can highlight two interesting facts to give us some much-needed context:

  • Rain’s valuation is higher (partly) due to a lower discount rate

Rain is valued used the discounted free cash flow methodology. As an early-stage, fast-growing and likely free-cash-flow-negative business, this methodology makes sense. A key input here, though, is the discount rate used.

Simply put, for the exact same free cash flows, a lower discount rate will arrive at a higher valuation, and visa versa.

In FY20, ARC used a discount rate of 17.25%, but in FY21 this discount rate has been lowered to 15.26%. That is quite a large drop in this discount rate and, surely, is a material contributor to the higher fair value of Rain in ARC’s INAV.

I would argue that if this is the case, then this ‘growth in fair value is particularly low quality.

  • Rain’s valuation implies that it is almost the same size as Telkom

ARC’s R3.3 billion fair value for its 20.2% shareholding in Rain is after respective around 12.5% minority and marketability (liquidity) discounts.

Read: Rain attracts R12.5bn valuation (Sep 2019)

While we will keep the minority discount (this will make sense later), if we add back the marketability discount and then gross the fair value up to 100%, we get what the implied ‘market cap’ for Rain should be if it was listed on the JSE.

(We keep the minority discount because JSE share prices reflect what minorities are willing to pay for small stakes in companies, thus this discount is still applicable even for a listed company’s shares.)

Doing this math, Rain’s implied listed market cap should be around R18.8 billion. To view this in context, Telkom has a market cap of only R18.6 billion.

Can Rain really be worth more than Telkom’s entire operations and its more than 26 million subscribers?

Read:

Furthermore, if we look at Blue Label Telecoms’ carrying value of its investment in Cell C, it is currently worth zero on its books. Cell C has 12.3 million subscribers.

How many subscribers does Rain have?

Well, the last data point we have was some months ago that they were signing up between 60 000 and 80 000 subscribers per month. Even if we assume they are now signing 100 000 per month and have been for the last five years (unrealistic, I know), this still only implies that Rain would have around six million subscribers, which is far short of both the above-noted (and lower-valued) tertiary telcos.

Thus, Rain’s valuation just looks odd.

So while plenty has been spoken around ARC’s fee structure, I don’t think enough has been asked about its valuation of Rain. While Rain does sound like it is performing well, is it performing well enough to justify the valuation that has been attached to it?

Listen to Fifi Peters’s interview with ARC co-CEO Johan van der Merwe (or read the transcript here):

Keith McLachlan is investment officer at Integral Asset Management.

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Best article I’ve seen from Keith.

Changes in the discount rate are likely to be mechanical. If the yield on government bonds changes the “risk-free” rate changes. There has been a fair amount of volatility on SA government paper in the last 18 months, and hence the implied risk free rate would have moved. Similarly for the equity risk premiums. Also if leverage of the group is changing over time in the debt / equity split could potentially cause lower WACCs. (Assuming CAPM is being used here.)

In a DCF the capex for 5G will most definitely be included in the FCFF, so whilst they might communicate the performance ex capex for marketing purposes, it should be taken into account for the DCF.

Wrt to the Telkom comparison, one needs to look at growth prospects. It is likely that the historic cost base of Telkom is far greater than that of the long term one needed to operate Rain. Look at the listed tech stocks globally we know the market is willing to pay up for potential growth / lower cost bases. Who do we think has better growth and lower cost prospects in the long term, Telkom or Rain?

Cell C isn’t worth mentioning really as they are defaulting on their debt. So regardless of subscriber numbers – they aren’t a suitable comp.

If we have concerns over the valuation then we should ask management to provide more detail on their inputs into their valuation, sense check these, and run our own valuation.

Fantastic critical analysis; auditors take note.

Would be interesting to see whether management fees are calculated based on these valuations and how potential conflicts are managed.

Nice to know there is a successful company out there able to provide telecom services where fibre is not deployed.

They also have little baggage a la the 2G/3G era. 5G at high frequencies remains a challenge because because tower density is not high enough.

Rain is fast becoming a very slow network.

I will be leaving it soon for telkom.

End of comments.

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