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February 25, 2008

Reviewing Rogers Communications

I feel I have done a good job and a bad job with Northlake's investment in Rogers Communications (RCI). On the one hand, I initially purchased RCI for clients in December 2006 around $29. With the stock at $39, up 34%, I should have no complaints. However, in early November the stock was in the low $50s, and it ended 2007 at $25.25. Unlike a lot of my big winners, I didn’t trim my RCI position on the way up. It is a loser on more recent new money or new client purchases and it has hurt clients' absolute and relative performance meaningfully so far in 2008.

The company reported 4Q07 financial results on Friday. The numbers were pretty good but there was not that much suspense as the equally important year end subscriber statistics and 2008 guidance was issued in mid-January. The subscriber metrics and guidance were both disappointing, compounding the investment case for the shares following initial worries about the May spectrum auction which will bring new wireless competition to Canada. The official auction rules were viewed as more favorable to new entrants than expected and as the current market leader and sole GSM provider in Canada, investors worry that RCI has the most to lose.

With the 4Q07 results in the books, I thought it would be a good time to review the investment case for RCI. I plan to continue to hold the shares but don’t expect to make real good money until the second half of the year. Developments surrounding the May 27th spectrum auctions, including the announcement of bidders on March 4th, seem likely to weigh on investor sentiment especially with new worries about flat rate pricing pans in the US and the spillover effect of a US recession.

However, I expect the stock to do much better and head back to at least the mid-$40s by year end. There are five reasons for my optimism. First, the shares are cheap at 7.4 times 2007 estimated EBTIDA. Second, growth remains robust with guidance calling for EBITDA growth of around 13% this year. Third, management has a consistent record of beating guidance. Fourth, the 4Q07 results and the conference call commentary reinforce that guidance is conservative and that the company is well prepared with its eyes wide open as far as new wireless competition is concerned. Fifth, the shareholder friendly actions taken in January, including a doubling of the dividend and initiation of a share repurchase show that management is effectively balancing competing shareholder interests of return of free cash flow and reinvestment in the operating businesses.

Wireless is the key to the RCI investment story as it provides 70% of projected 2008 EBITDA. RCI is the industry leader with 40-50% of net adds in Canada. Wireless penetration in Canada is well below the US but on the same penetration curve. If Canada follows the US penetration for several more years, subscriber growth should remain robust, enough to provide RCI, current competitors BCE and Telus, and new entrants with double digit growth.

RCI has benefited from operating the only GSM network in Canada. This gives the company dominant share of highly profitable international roaming revenue and the cheapest and best selection of handsets. New entrants via the spectrum auction will cut into these competitive advantages but it will be years before they are able to build out their own networks. Until that point RCI will be paid for roaming and access to its towers by the new entrants....

....The bigger risk is that new entrants upset the pricing structure in Canada leading to falling voice ARPU. This risk was heightened when US carriers moved to flat rate pricing plans last week. 4Q gross and net adds in Canada for all the wireless carriers were below expectations further raising worries about new entrants. Is Canada falling off the US penetration curve? Some believe that is the case and that new entrants will re-accelerate sub growth by offering cheaper voice plans (voice is much more expensive in Canada than in the US). RCI management said on the 4Q conference call that they believe that sub growth is seeing shifting seasonality from the 4Q holiday season to the 3Q back to school season because many new subs are coming from the youth market. This is a reasonable explanation and the youth market was penetrated later in the US but there won’t be a clear answer on this until late in 2008.

RCI's 4Q07 financial and subscriber results suggest the company is well positioned to deal with whatever environment develops in Canada this year. Sub growth was light but management said it did not respond to competitive rate activity. This is evident in the fact that cost per gross add and ARPU were in line with expectations and wireless margin still grew by over 300 basis points. 4Q07 wireless revenue growth was 17% with EBITDA rising 26%. Management went further and stated that so far they are seeing no slowdown in subscriber growth due to economic or competitive factors but they are still focusing on cost savings in case growth does slow. This statement speaks to the high quality of RCI management which not only focuses on quarterly results but thinks ahead about costs and capital spending. As noted earlier, the company has laid out a financial plan that rewards shareholders by returning a significant portion of rapidly growing free cash flow (the stock has about a 10% free cash flow yield) with ongoing investments in the asset base and corporate infrastructure to support growth and protect against competition.

I believe RCI longs will be rewarded by investors later this year when sentiment improves following the wireless auction as RCI reports results and shows it is on track to at least meet its 2008 guidance. Modest expansion of the multiple to 8 times gets the stock back to $35, up 16%. 8 times is not a stiff price to pay for double digit growth in operating income and free cash flow, a superior and shareholder friendly management team, and a company that would be very valuable if regulatory trends toward loosening international ownership of Canadian companies continue.

Posted by Steve Birenberg at February 25, 2008 10:58 AM in RG