1HFY12 Results Review note

M1 surprised on the downside with 1HFY12 results that missed the street and our estimates, no thanks to the accounting treatment for Android handsets, which clobbered EBITDA margin. Management has maintained its dividend payout ratio of 80% of earnings, which would imply a lower absolute payout for FY12 given the pressure on earnings. We cut our FY12/13 forecasts by 9%-12% post results to err on the conservative and downgrade the stock to NEUTRAL, with a revised DCF FV of SGD2.66. We are also moderating our DPS assumption for FY12 to 14 cents/share.

Below forecasts. M1’s core earnings, when annualized, were 12%-16% below our and consensus estimates. The key disappointment came from an accounting anomaly in the treatment of Android handsets which deviated from the usual fair value accounting it adopts for the iPhone (amortization over the life of the contract). M1 expensed upfront the cost of Android smartphones, which made up 70% of all smartphones sold in 2Q12. This hammered margins even as the subsidies on the models fell, as evident from the decline in subscriber acquisition cost (-12% q-o-q). The telco estimates that 25% of its total base comprises Android handsets versus 50% for the Apple iPhone.

IDD, fixed services revenue down q-o-q. To our surprise, service revenue contracted 0.7% q-o-q (+1% y-o-y), dragged down by weak IDD revenue (-7% q-o-q) and fixed services revenue (-4.2% qo-q). M1 said IDD sales were hit by the lower roaming revenue after Singapore and Malaysia signed a reciprocal agreement to lower roaming tariffs in 2011. Despite booking in another SGD7m in wholesale cost to expand its fiber footprint, its fixed service revenue was still down sequentially as there was a one-off sale of fixed equipment in 1Q12. M1 netted 7k fiber subs in 1Q12 to 37k, which translates into a fiber market share of some 21%-23% based on management’s estimate.

Tiered data plans by September. M1 said it will introduce tiered data plans when its LTE service goes nationwide in 3Q12 but did not provide any details. Both M1 and StarHub have yet to respond to Singtel’s earlier move to lower its data caps.

Dividend payout may be at risk. While M1 kept its dividend payout guidance at 80% of earnings, it would appear that the absolute dividend for FY12 could potentially be lower due to the earnings impact arising from the accounting mismatch. Management was unable to provide guidance on whether this impact would stretch into 2H2012. We cut our FY12 and FY13 core earnings forecasts to SGD156.8m and SGD187.7m respectively from SGD177.4m and SGD206.8m previously to build in mid-term earnings pressure from the upfront expenses relating to Android handsets. Our DPS estimate is cut accordingly, although M1’s dividend yield is still a decent 5%, which should provide some share price support.

Subsidy Hiccup

Downgrade to HOLD. M1’s full year earnings outlook is now more uncertain on a 2Q12 miss, and the company has withdrawn its earnings guidance. The current re-rating of the stock is likely to be cut short for now. We have cut our FY12 forecast by 5%, which could fall further if demand for iPhone 5 is stronger than expected. We are not totally negative on M1 as there is a chance Android will hold its ground. Although we usually steer clear of neutral calls, we reckon this uncertainty should clear up within a couple of quarters. Its longer term catalysts such as data monetisation, 4G and NGNBN are still valid. Fair value is pegged at peer average PE of 14x or SGD2.45 for now.

2Q12 below expectations despite lower iPhone sales. M1 reported lower-than-expected net profit of SGD35.3m, down 18% YoY and 12% QoQ. Although subsidies fell on greater demand for Android handsets in 2Q12, margins were hit by its accounting treatment for Android handset subsidies (which differ from iPhones) as M1 did not recognize any service revenue upfront to offset the handset cost as it does with iPhones. 70% of handsets sold during the quarter was Android, mainly the high-end Samsung S3, pushing SAC down 12% QoQ to SGD320.

Full year earnings guidance withdrawn. Earnings outlook will be uncertain for the next two quarters as we are not sure how strong Android handset sales will be in the face of a new iPhone. Higher Android adoption should be long term positive for margins and future revenue but M1’s accounting policy is muddling the short term picture. The best case is for flat margins in 3Q12 if users hold off and wait for the iPhone 5, and the worst case is if iPhone 5 demand surges in 4Q12. Neither case is very positive for M1 in the short term.

Longer term catalysts still valid, but overshadowed for now. We believe catalysts such as revenue and margin upside from data monetisation, its early mover position in 4G and the lifting of service activation bottleneck in NGNBN will still be valid for M1. However, those are longer term catalysts and for now, will be overshadowed by the confusion caused by its different accounting treatments for iPhone and Android handset subsidies, as well the earnings uncertainty arising from Apple’s upcoming iPhone 5.

Below expectations

Company Overview

M1 is the 3rd largest Telecommunications company in Singapore. The introduction of NGNBN in Singapore lowered entry barriers to the Fixed Line business, which would allow M1 to venture into the corporate and retail broadband market.

• 12.9% Q-Q decline in Net profits on amortization of handset revenue

• 0.7% Q-Q decline in Service revenue to S$190.4 million

• Maintain Reduce with TP of S$2.38

What is the news?

M1 reported 12.9% q-q decline in Net profits due largely to a 40.9% decline in revenue from sale of handset. This is due to accounting treatment, in which revenue from the sale of non-iPhone handsets are amortized over the 24 months contract. Service revenue was also disappointing with decreases in pre-paid revenue, International call services, and fixed services.

How do we view this?

The results were below our expectations, although largely due to the phone’s accounting treatment. We note the weak performance in Service revenue and continued slow take up rate of Fibre broadband despite M1’s aggressive pricing. Improvements in service revenue or positive developments such as gaining back previously lost market share would be needed to warrant an upgrade.

Investment Actions?

We adjust our figures to reflect the lower upfront recognition of revenue from handset and 2Q12 earnings. We maintain our Reduce rating with an unchanged TP of S$2.38.

Softer 2Q12 earnings

• 2Q earnings 15.4% below forecast

• Not expecting stable performance for FY12

• Paring fair value to S$2.80 from S$2.81 Softer-than-expected 2Q12 showing

M1 Ltd reported a softer-than-expected set of 2Q12 results yesterday. Revenue of S$232.2m was down 5.3% YoY and 11.5% QoQ, or 7.1% below our estimate. Management explained that the lower revenue was due to lower handset sales. Due to a change in sales mix, with nearly 70% of its post-paid customers adopting an Android phone, which subsidies are expensed upfront, net profit tumbled 17.8% YoY and 12.7% QoQ to S$35.2m, or 15.4% below our forecast. Meanwhile, M1’s 1H12 revenue fell 1.6% to S$494.7m, making up 45.0% of our FY12 forecast; while net profit slipped 11.5% to S$75.5m, or 45.8% of our full-year estimate. Nevertheless, M1’s interim dividend remains at S$0.066/share, unchanged from last year.

Removes stable outlook guidance

Going forward, M1 expects capex to be around S$120m, versus its earlier S$110-130m guidance. But we note that management has not reiterated its “stable performance at both top and bottom-line” guidance. Instead, M1 guided that the strong interest in new high-end smartphones seen in 2Q will contribute to revenue growth over a two-year period. It also expects handset subsidies expensed upfront to have an immediate impact on profitability, but believes that margins will recover over the 2-year contract period. Meanwhile, M1 is looking to be the first telco in Singapore to have a nation-wide 4G smartphone and dongle coverage by end-3Q. However, the adoption of this new technology could take up to 2 years to reach an optimal level, the higher roll-out cost could depress near-term margins.

5.4% lower FY12 earnings forecast

In view of M1’s latest guidance, we are revising down our FY12 revenue forecast by 3.4% (mainly on lower handset sales) and earnings by 5.4% (on weaker margin outlook). We also kept our FY13 revenue forecast but cut earnings by 2.6%. However, with our DCF-based model, the earnings cut only has minimal impact on our fair value, reducing it from S$2.81 to S$2.80. Lastly, free cashflow remains strong, reflecting M1’s defensive earnings and ability to sustain a dividend payout ratio of 80%. Maintain BUY.

Android accounting impact

M1’s 2Q12 core net profit missed our forecast and consensus by 16% and 11% respectively due to the accounting of non-iPhone device subsidies. Despite lower earnings, M1 pledged to maintain absolute DPS. It declared a 1H12 DPS of 6.6 cts, unchanged yoy.

We maintain Neutral on M1 but raise our DCF-based target price by 14% to S$2.86 on: 1) lower subsidies given the rising popularity of the lower-cost Android devices vs iPhones and 2) lower WACC of 7.6% vs 7.9% to reflect its fairly attractive dividends. We also adjust our FY12-14 EPS forecasts by -7% to +3%. StarHub remains our top pick.

Profitability impacted by accounting

Although its cashflows are unaffected, M1’s margins were impacted negatively by its accounting treatment for Android devices where the subsidies are expensed vs being amortised over the contract period for the iPhones. We suspect that this impact will carry over to 3Q12 as the very popular Samsung Galaxy S3 had only a one-month impact in 2Q12 since it was launched in end-May. Android devices made up about 70% of the total devices sold in 2Q, a reverse from previous quarters where the iPhones dominated. However, we think margins should improve thereafter when: 1) the new iPhone is launched, typically in 4Q, and 2) the impact of the Samsung Galaxy S3 washes through.

Outlook

Not surprisingly, M1 expects a “short-term” impact of handset subsidies on its profitability. It reiterated FY12 capex of S$120m. M1 views OpenNet’s 29% higher installation quota positively, but feels that it is insufficient to reduce the service activation period.

Maintaining dividends

Despite net profit being weighed down by expensing subsidies, M1 pledged to maintain its absolute FY11 DPS in FY12, i.e. by raising its payout ratio. The company said that it planned to maintain its FY11 absolute DPS of 14.5cts for FY12. It declared an interim dividend of 6.6cts (80% payout vs 70% in 1H11).