2008 likely to be challenging year

Key drivers in 2008. Looking into 2008, Singapore’s telco sector is likely to face some issues. This includes S$ appreciation vis-à-vis other currencies, stock market volatility, nationalistic sentiment against sovereign company/fund investment, higher inflation rates. Against this uncertain climate, our stock selection criterion is defensiveness in earnings. We prefer telcos with pure Singapore exposure, high earnings visibility, high dividend payout and with a non-aggressive growth strategy.

Number portability encourages switching. Mobile Number Portability (MNP) will be introduced in 2008, and this is likely to be preceded by intensive competition to lock in existing and new customers. There is some evidence that aggressive marketing has already started, and this is reflected in some telcos’ willingness to sacrifice revenue growth at the expense of subscribers. Our OIR’s Economic Matrix shows this clearly. With anticipated competition, there is likely to be margin erosion. However, depending on the individual telcos growth strategy some could be affected more than others.

NBN: Does return justify investment? 2008 will see the bidding for the National Broadband Network (NBN). Investment in the NBN network is expected to run into the billions and its tariff charges are likely to be heavily regulated. The return is unlikely to be very high, as it is on a competitive bid basis, tariff charges are likely to be regulated, and return may not commensurate with the high investment costs.

StarHub reigns supreme in pay-TV market. In 2007, SingTel entered the Pay-TV arena with Mio TV. However, we do not see the take-up rate to be high and this perhaps explains SingTel’s promotion to offer free Mio TV with its broadband packages. We see Mio TV to need to revamp its content and differentiate itself to tap onto undiscovered demand to compete in the Pay-TV market.

StarHub and M1 our top picks for 2008. As we move into 2008, telcos are likely to face a challenging environment on both the macro and micro fronts. Our stock selection criterion is thus defensiveness in earnings. In that context, our preferred telcos are StarHub and MobileOne (M1).

A less bumpy ride on the way up

• 3QCY07 results in line, Singapore telco service consumption growth intact. Earnings for the three telcos came within our expectations. The key positive was robust 9.5% yoy revenue growth for the sector, driven by mobile and broadband, which both grew 12% yoy. The key negative was margin pressure due to unique factors at SingTel (strategic initiatives and increased contributions from low-margin IT sales) and StarHub (lag in passing on higher BPL costs). Overall, Singapore’s telco service consumption growth remains intact on the back of an immigration boom and a robust domestic economy.

• Positive outlook for 2008. The migration boom and the fastest rise in wages in seven years provide a promising backdrop for telco services for 2008. In addition, we expect wireless broadband and 3G services to provide upside to growth expectations on greater availability and affordability of user-friendly 3G handsets as well as the introduction of service innovations such as capped data plans. Margins in 2007 hit a low and we expect improvements in 2008. However, the scope of margin expansion should be capped by structurally higher retention costs with mobile number portability (especially at SingTel) and no let-up in intense but rational competition.

• StarHub and SingTel should be the biggest winners. Although all three telcos should benefit from subscriber growth, StarHub stands out for its potential ARPU growth (postpaid mobile and pay TV) while SingTel should be driven by mobile subscriber market-share gains. StarHub’s best-in-class bundled offerings make it the best stock to own for telco service consumption growth in 2008. We expect M1 to be increasingly marginalised for lack of bundling capability.

• Robust free cash flow yields supportive of above-consensus prospective yields. We reiterate our view that there is significant scope for consensus to re-rate dividend expectations for the Singapore telco sector. We expect the sector to deliver an average CY08 dividend yield of 8.4% (consensus: 6.0%), fully backed by free cash flow from robust topline growth, limited capex and strong balance sheets.

• Maintain Overweight; StarHub our top pick, followed by SingTel. Singapore telcos offer attractive risk-reward in terms of historical EV/EBITDA valuations. The sector also offers reliable earnings from an immigration influx, the proliferation of 3G/wireless services etc. Finally, downside risks should be limited given hefty prospective yields on robust free cash flow. Key risks are irrational competition and NBN but these are on the low side. StarHub is our top pick for its bundled offerings and greatest scope for upside surprises on the ARPU front. SingTel is our next preferred pick for prospective subscriber market-share gains in Singapore and exposure to high-growth regional markets.