TPG Telecom Relying Heavily On Mobile

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The main risks going forward for TPG Telecom are the erosion of margins as the NBN roll-out completes. Brokers suggest the company will need to rely heavily on mobile revenue.

-Maintains strong record of cash conversion in FY18
-Is there a better entry point for investors down the track?
-Significant earnings growth needs to come from mobile
 

By Eva Brocklehurst

There were few surprises in the TPG Telecom ((TPM)) FY18 results, given guidance was provided just several weeks beforehand and brokers are focused on the upcoming plans to merge with Vodafone Australia.

FY19 operating earnings (EBITDA) guidance of $800-820m is slightly conservative, brokers believe, and lower organic growth is signalled. The main risk, Morgans asserts, is the erosion of margin in the NBN, to be offset by cost reductions, although the company has done a commendable job in reducing costs and simplifying acquired businesses.

The company maintained its strong record in cash conversion over FY18, at 103.2%, and Macquarie expects this to revert to around 100% going forward as subscriber growth is now benign. Consumer revenues were flat and gross profit in consumer broadband declined by -3.9% for the year. Fixed voice revenue is in structural decline, down -30.5%, and mobile revenue declined -5.4%. The company returned to minor mobile subscriber growth in the second half.

Citi was surprised at the lower capital expenditure in FY18, which totalled $956m versus forecasts of $1.09bn, with the main difference being expenditure of only $39m on the Australian mobile network. The broker raises FY19/20 estimates for earnings per share by 18% to reflect stronger earnings and lower expenditure, although is yet to incorporate Vodafone Australia into estimates.

Citi forecasts a further three years of earnings decline from the consumer division with scope to grow earnings from FY21 once the NBN is complete and legacy voice and iiNet revenues are out of the system.

Ahead of this, earnings growth will need to come from mobile and cost synergies from the merger. Ord Minnett suspects that the current share price is trading with a premium based on the CEO/founder David Teoh engineering a merger he has long wished for and suggests there will be a better entry point for investors down the track.

Roll-outs

The company provided more detail on its Fibre1000 product, looking to be highly disruptive by offering 1GB per second links, aggressive pricing and flexibility to manage the capacity at low cost. Macquarie suggests,if successful, incremental margin should be high given the on-net nature and efforts by TPG Telecom to automate much of the process.

Outdoor coverage is almost complete in Singapore and the broker envisages expenditure for the roll-out being at the low end of guidance. Prior to the merger being completed the TPG board intends to separate the Singapore company by way of an in-specie distribution of shares to existing TPG shareholders.

Meanwhile, the Australian mobile network roll-out continues ahead of the proposed merger with Vodafone Australia. TPG Telecom believes the network will be complementary to the existing Vodafone network and bring additional capacity and coverage.

Merger

The proposed merger with Vodafone Australia makes sense to UBS, being highly complementary from a customer perspective. Analysis suggests some overlap with the customer base, as around 33% of Vodafone subscribers use a TPG/iiNet broadband service and 49% of TPG/iiNet households use Vodafone, TPG or iiNet mobile.

Outside of this, the company is expected to cede -$15 for every iiNet legacy voice subscriber as a result of the NBN and gross profit will decline by around -$13-14 for every DSL subscriber that transitions to NBN. This will result in, in the broker's estimates, a negative -$200m outcome. Therefore, going strongly into the mobile sector is considered a logical step and a merger less risky than a network roll-out.

In terms of risk, UBS believes, if the ACCC defines the market narrowly as "mobile", there is less risk than if it defines the market as "converged" fixed & mobile. The companies may argue that the merger creates a strong third player to compete with Telstra ((TLS)) and Optus but there is also the consideration regarding potential removal of a vigorous and effective competitor. UBS suggests undertakings may be the solution to ACCC concerns.

Citi now shifts to value TPG Telecom on a post-merger basis and, while there may be delays, does not expect that regulatory intervention will be an problem. The broker suggests earnings growth must now come from mobile as valuation is stretched, maintaining a Sell rating.

Morgans recently upgraded to an Add rating, based on significant value over time being realised through synergies. The company expects the deal to be completed in 2019, subject to relevant approvals. On a pro forma FY18 basis the combined group will generate revenue of $6.1bn and free cash flow of $900m.

Vodafone has extinguished some of its debt burden so the combined group would have net debt of $4bn. The broker suggests this places the merged business in a comfortable gearing position and just slightly ahead of the target of 1.5-2x operating earnings.

The combined group will pay around 50% of normalised net profit out in dividends and have around 2bn shares on issue. Morgans estimates cost synergies alone could be in the region of $500m. TPG Telecom also recently made an application by the joint venture to bid in the upcoming 5G auction in November, regardless of the merger.

FNArena's database shows two Buy ratings and three Sell. The consensus target is $7.81, signalling -5.8% downside to the last share price.

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