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July 31, 2007

Good Quarter, Bad Reaction For Rogers Communications

Rogers Communications (RCI) reported 2Q07 earnings on July 31st. The results were at the upper end of expectations and management raised the high end of the guidance range for many key metrics. Nevertheless, the shares traded off as much as 4% initially, cut the loss in half as the conference call was occurring, and closed down 5% succumbing to the last hour sell-off in the market..

I think the negative reaction to a solid earnings report occurred for five reasons. First, expectations were too high given that Rogers' shares had risen over 30% since the last quarterly report due to heightened takeover activity in Canadian telecom and recognition of the growth and profitability of the company's #1 position in Canadian wireless telephony. Second, this quarter was not the blowout positive surprise that the company had usually provided over the past six quarters. Again, the expectations game worked against the shares. Third, the guidance increases were widely expected and the new ranges did not exceed current analyst estimates. Fourth, margins at Rogers Cable retreated for the second consecutive quarter. Finally, the company was quiet on further uses of the growing free cash flow to enhance shareholder value. Additional dividend increases, tuck-in acquisitions, and capital spending to "bullet proof" the company's network and customer service infrastructure for the cable and wireless businesses were mentioned. Major acquisitions and share repurchases were ruled out. I believe that some investors were looking for a more aggressive stance including a major share buyback.

Despite the reaction of the shares, I came away from the quarter more positive on Rogers. Plugging fresh numbers at the high end of the upwardly revised guidance raises my target for the shares to $54. Two major factors are at work. Wireless is booming and free cash flow in 2008 looks even better than I had thought....

In Wireless, Rogers beat consensus again with 13% service revenue growth and 21% EBITDA growth on margins of 51.7%. Postpaid net adds were 133,000, about 20,000 ahead of consensus, and postpaid churn fell to just 1.15%. These figures give me confidence that 2008 will see mid-teens EBITDA growth on the back of further top line growth and sustainable margins over 50%. Wireless is by far the most important driver of Rogers stock price so this is good news indeed.

On free cash flow, the company raised the top end of guidance by 15% to $1 billion and did not deny analyst questions that they would meet or exceed the top end. This gives me confidence to flow through most of next year's 15-17% EBITDA increase to free cash flow, benefiting the stock price by an incremental $1-2 per share.

Besides an unexpected slowdown or margin contraction in wireless the areas of risk to Rogers are capital spending and cable. Management may raise capital spending more than expected to "bullet proof" the company, cutting into my free cash flow projections. In cable, Rogers has suffered some margin contraction this year and margins trail peers by 500 basis points. Rogers chalks up the margin shortfall to a focus on rapid subscriber growth and the transition of circuit switched telephony to VOIP. If margins don’t begin to expand, there could be multiple compression on the cable business which is implicitly valued above Comcast in a sum of the parts valuation model.

My bottom line is that Rogers remains a great idea for fresh money given strong growth characteristics, rapidly growing free cash flow, and possibility that someday Ted Rogers may decide to listen to an offer from a financial or strategic buyer.

Posted by Steve Birenberg at July 31, 2007 12:31 PM in RG