Strong cash flow generation despite continued top line pressure; guidance revised

Budapest, August 5, 2010 00:00

Magyar Telekom (Reuters: NYSE: MTA.N, BSE: MTEL.BU and Bloomberg: NYSE: MTA US, BSE: MTELEKOM HB), the leading Hungarian telecommunications service provider, today reported its consolidated financial results for the first half of 2010, in accordance with International Financial Reporting Standards (IFRS).

Highlights:

• Revenues were down by 7.1% to HUF 297.8 bn in the first six months of 2010 compared with the same period in 2009. This was mainly due to lower fixed and mobile voice revenues in all three countries, together with a decline in Hungarian data revenues. These declines were partly offset by growing Hungarian mobile internet and TV revenues. However, the appreciation in the Hungarian forint resulted in lower revenue contributions from international subsidiaries, reflecting the translation impact (both the Macedonian Denar and the Euro weakened by 6.4% relative to the forint in the first half of 2010 compared to the same period in 2009).
• EBITDA declined by 8.8% to HUF 119.5 bn , with an EBITDA margin of 40.1%. Underlying EBITDA, which is EBITDA excluding investigation-related costs (HUF 1.4 bn in H1 2010 against HUF 3.6 bn in H1 2009), as well as severance payments and accruals (HUF 1.5 bn in H1 2010 against HUF 1.0 bn in H1 2009), decreased by 9.9%. Underlying EBITDA margin was 41.1% in the first half of 2010 compared to 42.3% in the same period of 2009. The lower levels of voice related payments, reflecting the lower traffic volume and the cut in the Hungarian mobile termination rates, and the decrease in other operating expenses driven by our cost cutting efforts, were not sufficient to offset the high margin voice revenue decline. Furthermore, the strengthening of the Hungarian forint also had a negative translation impact on the EBITDA contributions from our foreign subsidiaries. Additionally, in the first six months of 2009, EBITDA was helped by a one-time gain of HUF 1.4bn realized on the IKO-Telekom Media Holding transaction that was closed in the second quarter of 2009.
• Profit attributable to owners of the parent company ( net income) decreased by 27.5%, from HUF 44.7 bn to HUF 32.4 bn. The decline was primarily driven by lower EBITDA and higher income tax, only partly offset by lower net financial expenses. The significantly lower average interest rate more than counterbalanced the higher average net debt level, causing a decline in net financial expenses. However, income tax increased significantly due to the Macedonian tax law changes that took effect from July 2010, resulting in a one-time HUF 5.2 bn deferred tax liability increase related to the requirement to book corporate income tax on the profit reserves that are expected to be paid out as dividend later on to non-resident entities. This increase could not be offset by the lower tax base and the removal of the solidarity tax in Hungary from this year on. 
• Net cash generated from operating activities increased from HUF 89.0 bn to HUF 92.4 bn. The lower EBITDA was more than offset by an improvement in working capital, primarily thanks to our focus on working capital management and also to the release of severance-related provisions in the first half of 2009. Furthermore, net financial charges also declined compared to 2009 driven by a significantly lower effective interest rate, while tax payments decreased mainly due to the removal of the solidarity tax in Hungary. 
• Investment in tangible and intangible assets (CAPEX) decreased by HUF 13.0 bn to HUF 36.2 bn in the first half of 2010 compared to the same period in 2009. Of total CAPEX, HUF 9.4 bn is related to the Consumer Services Business Unit, HUF 1.6 bn to the Business Services Business Unit, HUF 1.0 bn to Group Headquarters and HUF 17.0 bn to the Technology Business Unit, whilst in Macedonia and Montenegro, CAPEX spending was HUF 5.1 bn and HUF 1.3 bn, respectively.
• Consequently, operating cash flow adjusted for investments in tangible and intangible assets as well as cash purchases significantly improved, from HUF 29.6 bn in the first half of 2009 to HUF 52.4 bn in the first half of 2010. Furthermore, free cash flow, defined as operating cash flow and investing cash flow adjusted for proceeds from / payments for other financial assets, improved on a similar scale, from HUF 30.0 bn in the first half of 2009 to HUF 53.4 bn in the first half of 2010, with the lower amount of proceeds from the disposal of PPE being more than offset by the proceeds from the sale of Orbitel.
• Net debt decreased from HUF 311.9 bn to HUF 297.1 bn by the end of June 2010 compared to the end of June 2009 level driven by the improved free cash flow performance. The net debt ratio (net debt to total capital) was 34.1% as at the end of June 2010.

Christopher Mattheisen, Chairman and CEO commented: “During the second quarter, the difficult operational environment continued to put pressure on our performance. Nevertheless, we continued to execute our strategy aimed at positioning Magyar Telekom as the leading integrated operator in Hungary. We introduced our first quadruple-play packages to the residential segment, which were well received by customers. In addition, we successfully concluded two acquisitions, of a cable and an IT company, in line with our expansion strategy. Thanks to this disciplined approach in executing our strategy, our market shares on the different markets remained unchanged and in some cases even increased further. We strengthened our market leader positions on both mobile voice and mobile internet markets, while we were the only major TV provider that managed to increase its market share in the recent difficult period and that brought us closer to our goal of becoming the market leader on the TV market as well.
Furthermore, the 1 ^st of July marked the implementation of the change in the Company’s management structure. We believe that this structural change will be beneficial in further enhancing our operating efficiency and in supporting the Company’s transition from a traditional fixed and mobile service provider to a more innovative communications, entertainment and information services company. In addition, this organizational change allows us to react with greater speed to changes in the market place and the wider economic environment, thus protecting our leading positions in the market.
Based on a Government resolution, the new Government plans to deliver HUF 20 billion of savings related to their 2010 budget for national asset management also including IT and telecommunication services. As a result of the requested price allowances, we expect a potential negative impact of around HUF 5-7 billion on both our revenue and EBITDA lines. Although we expect the economic indicators which drive demand for our services to start to show signs of recovery towards the end of the year, the above-mentioned government initiative will cause our full year revenue and EBITDA to decline more than previously forecasted. Consequently, we now project a 6-8% revenue and 7-9% underlying EBITDA decline for 2010.
Therefore, to reflect our strong focus on free cash flow generation, we have decided to cut our CAPEX target for this year. Instead of the originally planned 5% decline, we now intend to reduce CAPEX by approximately 10% compared to last year’s spending ^[1] .”

¹ The comparable figures for 2009 are: revenues of HUF 644.0 bn, underlying EBITDA of HUF 262.8 bn and CAPEX of HUF 101.9 bn.

Q2 2010 results analysis

Group

• Revenues declined by 6.6% in Q2 2010 compared to the same quarter in 2009. Retail voice revenues decreased in all markets, reflecting the unfavorable economic environment in Hungary and the intensifying competition at our international subsidiaries. At the same time, the lower Hungarian mobile termination rates introduced at the beginning of 2010 resulted in a wholesale mobile revenue decline. These could not be offset by the higher TV and mobile broadband revenues.
• EBITDA was down by 7.0%, while underlying EBITDA declined by 8.6% in the second quarter of this year. The EBITDA decline was a direct result of the lower revenues that could not be wholly offset by the cost cutting initiatives, primarily in employee-related expenses and other cost items, such as marketing and consultancy expenses. In the second quarter of 2009, EBITDA was also helped by a HUF 1.4 bn gain on the IKO-Telekom Media Holding transaction.

Consumer Services Business Unit (CBU)

Revenues before inter-segment elimination fell by 2.9% to HUF 78.2 bn and EBITDA increased by 0.7% to HUF 45.9 bn in the second quarter of 2010 compared to the same period of 2009. EBITDA margin increased to 58.6%, as our disciplined efficiency improvements more than offset the negative revenue impact.

• Fixed line revenues declined by 5.1% in Q2 2010, driven mostly by the voice revenue decrease as mobile substitution and migration towards IP-based solutions resulted in increased customer erosion, putting pressure on both average tariff levels and traffic volume. In addition, although the number of broadband customers continued to increase (reaching 625,000), internet revenues decreased by 1.4%, reflecting the declining tariffs and the higher migration towards lower priced packages. The negative impacts were partially offset by the growth in the TV customer base, resulting in a 12.8% increase in the second quarter TV-related revenues. The number of total TV customers exceeded 707,000 by the end of June with growth mostly driven by the satellite TV service, while demand for IPTV was also strong.
• Mobile revenues were down by 1.4% to HUF 46.8 bn in the second quarter as the declining number of customers coupled with lower average tariff levels could not be offset by higher usage. At the same time, the 16% cut in mobile termination rates effective from January 2010 negatively impacted wholesale revenues. Although T-Mobile’s customer base decreased compared to the June 2009 level, this was mainly due to increased churn of inactive customers and cancellations of double and triple SIM cards. Consequently, T-Mobile increased its market share to 44.7% amongst active customers. At the same time, the mobile internet market continued to expand dynamically and we witnessed a strong increase in both our subscriber base and revenues. The number of mobile broadband subscribers increased by 62.5% compared to the same period last year to exceed 506,000 as at the end of June 2010. Furthermore, T-Mobile managed to increase its leading market position further in mobile broadband and at the period end had a 50.9% share of traffic generating subscribers.

Business Services Business Unit (BBU)

Revenues before inter-segment elimination were down by 4.7% to HUF 39.7 bn while EBITDA decreased by 5.2% to HUF 18.7 bn in the second quarter of 2010. The EBITDA margin was held broadly flat at 47.2%, as the higher portion of revenues coming from the lower margin SI/IT services was largely offset by our cost cutting measures.

• Fixed line revenues were down by 13.4% to HUF 10.7 bn reflecting the difficult macroeconomic environment, which led to a contraction in business customers’ telecommunications spending. In the fixed line segment, revenue erosion accelerated as churn was high among voice, data and internet customers.
• Mobile revenues decreased by 3.3% to HUF 16.2 bn driven by a significant decline in the average tariff level that could not be compensated by higher levels of usage and the slight increase in our customer base. Furthermore, mobile revenues were also negatively affected by the cut in mobile termination rates effective from January 2010. At the same time, non-voice revenues increased thanks to the increasing usage of mobile broadband, and now represent 25.3% of ARPU generated by corporate clients.
• SI/IT revenues were up by 2.0% to HUF 12.7 bn in the second quarter of 2010. Although, in general, the investment levels are still lower both at the private and the public sector in response to the current economic environment, SI/IT revenues grew mainly because of some one-off IT infrastructure projects undertaken for financial institutions. Besides these projects, the consolidation of ISH, acquired in the second quarter of 2009, also positively impacted SI/IT revenues.

Macedonia

In Macedonia, revenues decreased by 8.7% to 19.6 bn in the second quarter of 2010 compared to the same period in 2009, with EBITDA declining by 10.0%. Excluding the FX impact (the Hungarian forint strengthened on average by 5.1% compared to the Macedonian Denar in the second quarter), revenues were down by 3.7% and EBITDA declined by 5.1%. The EBITDA margin declined to 56.9% compared to 57.7% in the corresponding period of last year, reflecting the pressure that intensifying competition is putting on prices, both in the fixed line and mobile segments.

• Fixed line revenues slightly declined by 1.0% in local currency terms. Although intense competition from alternative, cable and mobile operators resulted in a further decline in outgoing traffic volumes and a high annual churn rate, these trends were almost fully offset by higher wholesale voice revenues, driven by growing incoming traffic volumes and higher prices charged for international traffic termination. This positive impact was coupled with increasing demand for double and triple play packages, resulting in higher internet and TV revenues.
• Mobile revenues declined by 5.9% in local currency terms driven by intensifying competition. Despite the improving customer mix, the lower number of subscribers and the competition-driven tariff reductions put pressure on revenue levels. The postpaid ratio was up to 31.9% compared to 28.9% in the second quarter of last year, which, coupled with more widely used closed-user-group offers, resulted in higher MOU. Although mobile internet usage increased and the number of SMS messages was higher, non-voice revenues declined compared to the second quarter in 2009 due to promotions containing free and discounted SMS messages.

Montenegro

Revenues of the Montenegrin subsidiary were down by 10.3% to HUF 7.8 bn in the second quarter of 2010 compared to the same period in 2009, with EBITDA declining by 2.9%. However, excluding the FX impact (the Hungarian forint strengthened on average by 4.9% against the Euro in the second quarter of 2010 against the same quarter in 2009), revenues declined by 5.7%, while EBITDA was up by 2.1%. The increase in EBITDA was primarily driven by the tough cost efficiency measures that were implemented, particularly with respect to the recovery of receivables, marketing expenses and technological support costs. The EBITDA margin improved from 33.8% to 36.6%. At the same time, in Q2 2010 it was determined that a number of prepaid mobile fill-up vouchers had been misappropriated at Crnogorski Telekom. Accordingly, we reversed previously recognized revenues of EUR 0.8 million and recognized a provision of EUR 0.4 million in relation to VAT and other costs associated with the misappropriated vouchers, resulting in a negative EBITDA impact totaling EUR 1.2 million.

• Fixed line revenues declined by 1.5% in local currency terms in the second quarter of 2010 as increasing internet and TV revenues could only partly offset the lower retail and wholesale voice revenues. The decrease in retail voice revenues was due to increased mobile substitution brought about primarily by significantly lower mobile tariffs. The wholesale revenue decline was driven by a significant migration of international traffic towards Serbia where that traffic is now transited by our competitors. On the other hand, both internet and TV revenues increased considerably thanks to the strong growth in the number of ADSL and IPTV customers.
• Mobile revenues were down by 10.4% in local currency terms primarily due to the above mentioned one-off correction. Furthermore, the lower number of subscribers and the decrease in tariff levels could not be offset by the increased usage and improved customer mix, resulting in declining mobile voice revenues.

Technology Business Unit

Technology Business Unit is a cost centre responsible for the operations and development of the mobile and fixed network as well as IT management. Network and IT related investments are also generated by this Business Unit. Revenues at the Technology Business Unit declined by 22.3% to HUF 2.1 bn while the EBITDA loss narrowed by 4.4% to HUF -10.8 bn. CAPEX amounted to HUF 9.9 bn in the second quarter of 2010.

Group Headquarters

Revenues before inter-segment elimination were down by 10.8% to HUF 29.7 bn. The revenue decline was mainly driven by lower wholesale revenues, especially within mobile revenues, reflecting the 16% cut in mobile termination rates since the beginning of 2010. EBITDA loss widened to HUF -5.5 bn, as the decline in revenues and increased employee-related expenses could only be partly offset by the lower level of voice-related payments and other operating expenses.

In the course of conducting their audit of the Company’s 2005 financial statements, PricewaterhouseCoopers, the Company’s auditors, identified two contracts the nature and business purposes of which were not readily apparent to them. In February 2006, the Company’s Audit Committee retained White & Case, as its independent legal counsel, to conduct an internal investigation into whether the Company had made payments under those, or other contracts, potentially prohibited by U.S. laws or regulations, including the U.S. Foreign Corrupt Practices Act (“FCPA”) or internal Company policy. The Company’s Audit Committee also informed the United States Department of Justice (“DOJ”), the United States Securities and Exchange Commission (“SEC”) and the Hungarian Financial Supervisory Authority of the internal investigation.  

Based on the documentation and other evidence obtained by it, White & Case preliminarily concluded that there was reason to believe that four consulting contracts entered into in 2005 were entered into to serve improper objectives, and further found that during 2006 certain employees had destroyed evidence that was relevant to the investigation. White & Case also identified several contracts at our Macedonian subsidiary that warranted further review. In February 2007, our Board of Directors determined that those contracts should be reviewed and expanded the scope of the internal investigation to cover these additional contracts and any related or similarly questionable contracts or payments.  

For further information about the internal and governmental investigations, please refer to the Company’s quarterly reports for the first, second and third quarters of 2009 and the first quarter of 2010 furnished under cover of Form 6-K and the Company’s annual report on Form 20-F for the year ended December 31, 2009.  

On December 2, 2009, the Audit Committee provided the Company’s Board of Directors with a “Report of Investigation to the Audit Committee of Magyar Telekom Plc.” dated November 30, 2009 (the “Final Report”). The Audit Committee indicated that it considers that, with the delivery of the Final Report based on currently available facts, White & Case has completed its independent internal investigation.   

The Final Report includes the following findings and conclusions, based upon the evidence available to the Audit Committee and its counsel:

• The information obtained by the Audit Committee and its counsel in the course of the investigation “demonstrates intentional misconduct and a lack of commitment to compliance at the most senior levels of Magyar Telekom, TCG, and Makedonski Telekom during the period under investigation.”
• As previously disclosed, with respect to Montenegrin contracts, there is “insufficient evidence to establish that the approximately EUR 7 million in expenditures made pursuant to four consultancy contracts ... were made for legitimate business purposes”, and there is “affirmative evidence that these expenditures served improper purposes.” These contracts were not appropriately recorded in the books and records of the Company and its relevant subsidiaries. As previously disclosed, the Company has already reclassified, in the Company’s financial statements, the accounting treatment relating to certain of these contracts to more accurately account for these expenditures.
• As previously disclosed, there is evidence that certain former employees intentionally destroyed documents relating to activities undertaken in Macedonia by the Company and its affiliates.
• Between 2000 and 2006 a small group of former senior executives at the Company and the Company’s Macedonian affiliates, authorized the expenditure of approximately EUR 24 million through over twenty suspect consultancy, lobbying, and other contracts (including certain contracts between the Company and its subsidiaries on one hand, and affiliates of a Cyprus-based consulting company on the other hand). The Final Report concludes that “the available evidence does not establish that the contracts under which these expenditures were made were legitimate.”
• “The evidence shows that, contrary to their terms, a number of these contracts were undertaken to obtain specific regulatory and other benefits from the government of Macedonia. The Companies generally received the benefits sought and then made expenditures under one or more of the suspect contracts. There is evidence that the remaining contracts were also illegitimate and created a pool of funds available for purposes other than those stated on the face of the agreements.”
• In entering into these contracts and approving expenditures under them, the former senior executives knowingly caused, structured, or approved transactions that shared most or all of the following characteristics:
• intentional circumvention of internal controls; • false and misleading Company documents and records;
• lack of due diligence concerning, and failure to monitor performance of, contractors and agents in circumstances carrying a high risk of corruption;
• lack of evidence of performance; and
• expenditures that were not for the purposes stated in the contracts under which they were made, but rather were intended to obtain benefits for the Companies that could only be conferred by government action.  

The Final Report states that “the Investigation did not uncover evidence showing receipt of payments by any Macedonian government officials or political party officials.” However, the Audit Committee’s counsel did not have access to evidence that would allow it to identify the ultimate beneficiaries of these expenditures.  

Nothing in the Final Report implicates any current senior executive or Board member of the Company in connection with any wrongdoing.  

As previously disclosed, the Company has taken remedial measures to address issues previously identified by the independent investigation. These measures included steps designed to revise and enhance the Company’s internal controls as well as the establishment of the Corporate Compliance Program.  

Due to these measures, no modifications to the Corporate Compliance Program were viewed as necessary in response to the Final Report. This conclusion has been discussed with the Audit Committee and the Audit Committee has not made recommendations either relating to the Company’s compliance program or internal controls.  

The Company is continuing to assess the nature and scope of potential legal remedies available to the Company against individuals or entities that may have caused harm to the Company.  

As previously announced, the DOJ, the SEC and the Ministry of Interior of the Republic of Macedonia have commenced investigations into certain of the Company’s activities that were the subject of the internal investigation. Further, in relation to certain activities that were the subject of the internal investigation, the Hungarian Central Investigating Chief Prosecutor’s Office has commenced a criminal investigation into alleged corruption with the intention of violating obligations in international relations and other alleged criminal offenses. Also, as previously announced, the Hungarian National Bureau of Investigation (“NBI”) has begun a criminal investigation into alleged misappropriation of funds relating to payments made in connection with the Company’s ongoing internal investigation and the possible misuse of personal data of employees in the context of the internal investigation. These governmental investigations are continuing, and the Company continues to cooperate with those investigations.  

The Company, through its external legal counsel, has recently engaged in discussions with the DOJ and the SEC regarding the possibility of resolving their respective investigations as to the Company through negotiated settlements. The Company has not reached any agreement with either the DOJ or the SEC regarding resolution of their respective investigations, and discussions with both agencies are continuing. We may be unable to reach a negotiated settlement with either agency. Any resolution of the investigations could result in criminal or civil sanctions, including monetary penalties and/or disgorgement, against the Company or its affiliates, which could have a material effect on the Company’s financial position, results of operations or cash flows, as well as require additional changes to its business practices and compliance programs. The Company cannot predict or estimate whether or when a resolution of the DOJ or SEC investigations will occur, or the terms, conditions, or other parameters of any such resolution, including the size of any monetary penalties or disgorgement, the final outcome of these investigations, or any impact such resolution may have on its financial statements or results of operations. Consequently, the Company has not made any provisions in its financial statements as of June 30, 2010 with respect to the investigations. 

Magyar Telekom incurred HUF 1.4 bn expenses relating to the investigations in the first half of 2010, which are included in other operating expenses of Group Headquarters. 



Magyar Telekom recently became aware of misstatements at T-Mobile Macedonia relating to the recognition of certain deferred (prepaid) revenues for the first and second quarters of 2010, the years ended December 31, 2007, 2008 and 2009, and periods prior to 2007. Based on the results of the internal review to date, in light of the known amount of the misstatements and the lack of any indication that senior Magyar Telekom executives directed or knew of the misstatements, the Company has reached the conclusion that the misstatements were immaterial to the Company’s previously reported consolidated financial statements and are immaterial to the Company’s current consolidated financial statements and to its prior assessment that internal controls over financial reporting were effective.  The Company has adjusted the remaining balance sheet misstatement in the current period. 

The Company has extended its internal review to other accounts in relation to T-Mobile Macedonia.  The Company has informed its Audit Committee, its independent external auditor, the DOJ and the SEC of the commencement of the internal review relating to T-Mobile Macedonia.  We cannot predict when the internal review will be concluded, what the final outcome of the review will be, or the further impact, if any, the review may have on our previously issued or future financial statements or results of operations and on our prior assessment that internal controls over financial reporting were effective.

About Magyar Telekom

Magyar Telekom is Hungary's principal provider of telecom services. It provides a full range of telecommunications and infocommunications (ICT) services including fixed line and mobile telephony, data transmission and non-voice as well as IT and systems integration services. The business activities of Magyar Telekom are managed by two business units: Consumer Services (the home-related services brand T-Home and the mobile communications brand T-Mobile) and Business Services (T-Systems brand). Magyar Telekom is the majority owner of Makedonski Telekom, the leading fixed line and mobile operator in Macedonia and it holds a majority stake in Crnogorski Telekom, the leading telecommunications operator in Montenegro. Magyar Telekom's majority shareholder (59.21%) is MagyarCom Holding GmbH, fully owned by Deutsche Telekom AG.

This investor news contains forward-looking statements. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements. These statements are based on current plans, estimates and projections, and therefore should not have undue reliance placed upon them. Forward-looking statements speak only as of the date they are made, and we undertake no obligation to update publicly any of them in light of new information or future events.

Forward-looking statements involve inherent risks and uncertainties. We caution you that a number of important factors could cause actual results to differ materially from those contained in any forward-looking statement. Such factors are described in, among other things, our Annual Report on Form 20-F for the year ended December 31, 2009 filed with the U.S. Securities and Exchange Commission.

In addition to figures prepared in accordance with IFRS, Magyar Telekom also presents non-GAAP financial performance measures, including, among others, EBITDA, EBITDA margin, underlying EBITDA, underlying EBITDA margin and net debt. These non-GAAP measures should be considered in addition to, but not as a substitute for, the information prepared in accordance with IFRS. Non-GAAP financial performance measures are not subject to IFRS or any other generally accepted accounting principles. Other companies may define these terms in different ways. For further information relevant to the interpretation of these terms, please refer to the chapter “Reconciliation of pro forma figures”, which is posted on Magyar Telekom’s Investor Relations webpage at www.telekom.hu/investor_relations.