Australia | Sep 26 2018
Where do the benefits of large-scale mergers in the telecommunications sector lie? The eventual outcome may not be as it appears at first glance.
-Incumbent carriers stand to benefit the most from consolidation
-Consolidation of the mobile business in the UK did not lessen competitive intensity
-Telstra will need to work hard to retain market share in mobile
By Eva Brocklehurst
Competition is unrelenting among telecommunications companies and the proposed merger of TPG Telecom ((TPM)) and Vodafone Australia ((HTA) is raising speculation as to which of the major players will be a winner in the longer term.
The Australian Competition and Consumer Commission (ACCC) will announce its decision regarding the merger of the two on December 13 and, on balance, most brokers expect the merger to be accepted. UBS envisages less regulatory risk if the ACCC narrowly defines the market in which the two operate as mobile, and greater risk if it is defined as converged, or fixed-mobile.
On a pro forma FY18 basis, the combined group is forecast to generate revenue of $6.1bn, operating earnings (EBITDA), pre-synergies of $1.8bn, and free cash flow, excluding spectrum purchases, of $900m. Synergies, particularly on costs, could be substantial, and Morgans estimates these in the region of $500m.
TPG Telecom and Vodafone Australia are expected to argue that the merger creates a robust third player that will compete with Telstra ((TLS)) and Optus and there are strong incentives to compete on price. UBS suggests undertakings may also be a solution to any ACCC concerns.
Research at JP Morgan concludes that incumbent carriers stand to benefit the most from consolidation, with an uptick in average revenue per user across the industry and incumbent share prices generally higher post the consolidation. Conversely, the benefits to the merger participants appear underwhelming, with market share losses and elevated expectations creating subsequent pressure on the shares.
The broker has studied the aftermath of five mobile-mobile and fixed-mobile mergers around the world to look for patterns that could potentially apply in Australia. The study supports a positive view on Telstra, which JPMorgan rates Overweight, and a negative view on TPG Telecom, which the broker rates Underweight.
The fixed-mobile merger of TPG Telecom and Vodafone Australia most resembles the Belgium experience, JP Morgan suggests, where the fixed carrier, Telenet, traded higher on the original announcement because of the large expected synergies. Yet, while the revenue per user was lifted industry-wide, Telenet actually lost market share after the acquisition and its share price declined by -25% from the peak a year earlier.
JPMorgan also notes the consolidation of the mobile business in the UK did not lessen competitive intensity. Despite the merger of Orange and T-Mobile in 2010 to form EE, the presence of the four remaining mobile operators meant competition remained intense. Revenue per user took several years to stabilise for both participants.
Whatever the benefit it may derive from consolidation in terms of its fixed line business, Telstra will still need to work hard to retain market share in mobile, Citi asserts. Competition in mobile has intensified as Vodafone Australia is matching the Optus 30GB $36 SIM-only plan with a $35 plan.
Having historically maintained a price premium of around 20%, that allowed Telstra to maintain a dominant market share, its offering is now at a 40% premium to peers for SIM-only plans. The broker considers this gap too large and Telstra will need to adjust pricing again if it wants to hold market share.
While Citi raises its valuation of Telstra by 15%, moving to a separate valuation for the infrastructure company, a Sell rating is maintained, amid doubts that the company will generate sufficient cash flow to keep its dividend at $0.22 per share in the long-term. The infrastructure company is valued at $21bn, including $8.4bn from recurring NBN.
Moreover, as earnings decline over the next three years Telstra will need to cut debt levels. If the company were to change its capital management framework and allow higher gearing on the infrastructure company, and borrow to pay the dividend, this would let it fund a $0.22 per share dividend for some several years more.
This would only be a temporary reprieve unless earnings can be increased. Citi calculates Telstra will need to find an additional $700m in free cash flow over and above forecasts in order to pay a $0.22 dividend in the long-term.
Citi increases its target for the fourth major telco, Vocus Communications ((VOC)), to reflect increased confidence in the long-term earnings recovery, as well as rising valuations for the telco sector locally. A Buy rating is maintained as Vocus is the only large-scale telco offering revenue growth.
The broker raises the multiple applied to the enterprise & wholesale business and brings it into line with the multiple applied to TPG Telecom's corporate business, reflecting increased confidence in the long-term growth profile. Citi also raises the multiples on the company's consumer division, reflecting relatively stable earnings versus Telstra's fixed line and TPG Telecom's consumer business.
The company's Australia-Singapore cable went live two weeks ago and Vocus has already sold 2.5Tbps of capacity which is expected to grow rapidly now the cable is operating. Citi expects FY19 to be the trough in earnings for Vocus while envisaging significant scope for cost reductions in the longer term.
See also, TPG Telecom Relying Heavily On Mobile on Sept 19, 2018.
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