Regional associates – victims of high competition and low usage

Story: We are concerned that regional subscriber growth may not translate into earnings growth. ARPU and EBITDA margins of regional associates are under pressure, due to (i) intense competition in Indonesia, Pakistan and Bangladesh (ii) softening minutes of usage in Philippines on the back of weak economic outlook. While usage may recover with better economic outlook, high competition may continue to dent the group earnings.

Point: We want to highlight three key points.

Telkomsel earnings may continue to decline. While Telkomsel may show some improvement from 2QFY09 results, as minutes of usage (MoU) increase in response to sharp price cuts, its SGD earnings contribution is likely to decline 23% (Prev 14% decline) in FY09 and 10% (Prev 8% decline) in FY10. A part of it can be attributed to an 18% weakness in Indonesian currency (IDR). Our assumption of SGD/IDR of 7300 compared to current exchange rate of 8000 implies downside risk to our estimates. Revision in Warid, Bharti and Globe earnings. We project Warid to post losses of S$90m (Prev S$23m loss) in FY09 due to higher network rollout and borrowing costs. We project Bharti’s pretax SGD contribution to increase 1% (Prev 9%) in FY09 as a result of higher USD borrowing costs and 18% (Prev 17%) in FY10, reflecting the low base. Globe contribution could decline 10% (Prev 5% decline) in FY09 due to lower usage and grow 5% (Prev 0%) in FY10 as economy stages a recovery.

Open-ended guidance for associates. Following the 2QFY09 results, management lowered its guidance for regional associate’s pre-tax earnings contribution from “low-double digit growth” to “lower than last year”. However, the guidance did not specify whether single digit or double-digit decline. We estimate associate contribution in FY09 and FY10 could decline 15% (Prev 4%decline) and grow 6% (Prev 4%) respectively.

Relevance: We lowered our FY09 and FY10 earnings estimates by 5.1% and 5.5% respectively, which are 5% and 7% below revised street estimates respectively. Maintain FULLY VALUED, with SOTP-based target price of S$2.34. We advise investors to accumulate SingTel towards our trough valuation of S$2.02.

The Down Under adventure


Australian NBN process

Telstra submits non-compliant bid. Bidding for the Australian next generation broadband network (NBN) has come to a dramatic end with the favourite Telstra submitting a non-compliant non-binding proposal. Telstra will only submit a full bid if the government deigns to address a supposed lack of clarity over structural separation, 12-month negotiations under the RFP, concerns over detailed use of Telstra’s information and the government’s proposed commercial terms. Key details of Telstra’s proposal are as follows:

• Telstra will invest A$5bn on a self-funded network capable of providing 25-50 Mbps downlink to 65-75% of the population and downlink of 12-20 Mbps to the rest of the population.
• Telstra will roll out to 90% of the population if the government can provide A$4.7bn as a loan with concessionary interest.
• The network would be open access where Telstra would not seek legislative protection against competing infrastructure.
• Telstra would provide a A$29.95/month entry level 1Mbps retail plan.
• The proposal is subject to certain clauses such as no further separation (at the sub-ULL level).

Six bids received. Six bids were received, with Telstra, the Optus-backed Terria Consortium, Axia Netmedia and Acacia submitting national bids. The Australian government also received two state-based proposals from the Tasmanian state government and TransACT. Many details are shrouded in secrecy but the panel is expected to make its recommendation in eight weeks and an awarded is expected at end-Mar 09.

Criteria for RFP requirements of the NBN. To recap, the network:
• Should deliver a minimum of 12 Mbps to 98% of Australian businesses and homes.
• Is to be rolled out and made progressively operational over five years using fibre-tothe-node (FTTN) or fibre-to-the-premises technologies.
• Should earn the state a return for its A$4.7bn investment.
• Facilitate competition through an open-access regime that will give all service providers equal access to the network on a price and non-price basis.
• Should enable uniform and affordable retail prices to consumers, no matter where they live.

Evaluation criteria. Evaluation criteria for the RFP consist of the following:
• The extent to which the proposal meets government objectives for the NBN project.
• Capacity of the proponent to roll out, maintain, upgrade and operate the NBN.
• Nature, scope and impact of any legislative/regulatory changes needed to facilitate the proposal.
• Cost to the government.
• Acceptability of the contract terms and conditions proposed and the extent to which they depart from the notified commercial terms.
• The extent of the proponent’s compliance with the RFP.

Our comments

Spanner in the process…. Much confusion hangs over whether Telstra’s noncompliant proposal can be regarded as a valid bid although the Communications Minister has accepted it. We believe that Telstra is hedging its position by keeping all options open, including ruling itself out of the running if the government does not sit down to negotiate on its terms. Should that occur, Telstra’s chances will be reduced dramatically as its proposal is in contravention of the 98% population coverage criterion and is in non-compliance with the RFP. If the government capitulates and sits down to negotiate, there would be a huge outcry from the other bidders which could lead to more complications.

…which improves Optus’s odds. As such, we believe that the Terria consortium (to which Optus is a partner), along with Axia Netmedia (which has extensive FTTN experience in France, Canada and won the rights to Singapore’s NetCo) have emerged as the new favourites for the NBN but that is predicated on whether the government considers the proposal by Telstra as a bid and whether it will sit down to negotiate on Telstra’s terms. Axia is also a consortium member together with SingTel that won the bid to build the NetCo portion of Singapore’s NGNBN.

Negative if Optus wins… We would be negative if Terria/Optus win as the economics of the NBN is questionable despite Telstra’s aim to achieve an 18% IRR on its investment. We question the economics of the project given the astronomical estimated cost of A$10bn-15bn to be spent over five years, the long gestation period for this service, the slower speeds (minimum 12 Mbps for FTTN) vs. current wireless speeds (14.4Mbps for Telstra now and 21 Mbps by 2009), the retail pricing (which is unlikely to be significantly below current levels) and legislation which could be employed by Telstra over last-mile access.

We are especially concerned about funding as Optus is likely to shoulder the burden alone as its other consortium members lack the balance-sheet strength for a meaningful equity infusion. There has been talk that SingTel would contribute A$1bn- 2bn in equity for the project and an Optus spokesperson has said that “it (SingTel) would contribute whatever (funding) we needed to.” However, we believe that such injections would stretch SingTel’s balance sheet, which currently stands at 1.1x net debt/annualised EBITDA, and drain SingTel’s cash of S$1.1bn. This would hamper SingTel’s ability to pursue any acquisitive opportunities.

…as the incumbent holds the advantages. Telstra is actually in pole position by virtue of its incumbency, as it has the financial means, ownership of the copper network and passive infrastructure, scale and expertise. If Telstra loses, we believe it is likely to proceed with its own network along the lines of its proposal and roll out faster and gain access to consumers faster by undercutting the business case of the official NBN bid.

But neutral if it loses out. As in Singapore, we believe that Optus’s bid is more of a tactic designed to keep Telstra’s bidding honest. While never likely to gain complete structural separation given the lengthy litigation battle that would ensue and the cries by Telstra over a complete destruction in value, we believe that Optus has already achieved a positive outcome by gaining open access to the fixed network which would leave Optus room to attack the fixed market dominated by Telstra. It would also save Optus on capex which could be put to more productive use.

Valuation and recommendation

Maintain earnings forecasts, Neutral rating and sum-of-the-parts target price of S$2.72. Given the many moving parts and lack of transparency surrounding the NBN process, we are retaining our earnings forecasts and target price of S$2.72 for SingTel. Also intact is our NEUTRAL rating. We believe the stock lacks catalysts due to currency volatility despite its holdings in free cash flow-positive Tier-1 telcos in the region.

Underlying valuation now attractive

Now is the time to revisit STel; Upgrade to Buy
After a period of being cautious on STel, we are now more positive and upgrade it to Buy. We had previously argued that the implied valuation of the Sing/Australia business was too high and that it did not deserve to trade at a NAV premium. But recent price movements have eroded these arguments. Therefore, although we trim our target price to S$3.23 on various factors, we view current valuations as attractive and recommend Buy. Furthermore, we expect STel to become relatively more defensive although emerging market & FX exposure risks remain.

Underlying valuations now attractive
For much of 2008, STel traded at a NAV premium while Sing/Australia was often more expensive than the listed Associates. But STel now trades at a NAV discount and the core Sing/Australia ops have de-rated to 11-12x fwd PE (vs 20x at the peak). And as there is a strong correlation between the Sing/Australia fwd PE and subsequent STel price trends, any further downside should be limited. Given the NAV discount and the reduced core fwd PE, we view current prices as attractive.

Although forecasts and target price trimmed
We however trim our forecasts to reflect 1H08 performance, recent FX trends and recent adjustments to Associate forecasts. For example, FY09e underlying NPAT is reduced -12% to S$3.37bn especially as recent FX trends will impact 3Q09. Furthermore, FX changes, estimate revisions and new Associate valuations reduce our target price by 52 cents/share to S$3.23 (-14% on previous published).

Revised S$3.23 TP and upgrade to Buy. Risks: FX & competition
Our S$3.23 SOTP TP is based on S’pore S$0.88/share (DCF: 7.1% WACC, 0%g), Optus S$0.78/share (DCF: 9.6% WACC, 1% g), DB covered listed Assocs at TP, non-DB covered listed Assocs at market value and investment value for others. Given current valuations, the NAV discount and the reduced Sing/Australia fwd PE, we are now Buyers especially as we believe STel should be increasingly price defensive. Risks to our view and Buy rating include adverse FX trends, increasing competition and an emerging market sell-off.

Most negatives priced in

Recent sell-down brings value. SingTel, hit by concerns about the slowing growth prospects of its associates and the adverse forex impact on its earnings, was among one of the biggest losers among the telcos during the October sell-off. The stock lost about 25.2% of its value in that month alone, while M1 lost about 28.6%, StarHub about 7.8%, versus the STI’s 23.9% tumble. Although SingTel recovered slightly in November, it is still down over 38% Year-to-Date (YTD), bringing its valuation down to around 12.3x FY10F PER, which is below its 5-year average of 13.4x. In the aftermath of the sell-down, we believe that most of the negatives have been factored in.

Forex remains main concern. Nevertheless, we see the still-volatile forex swings as the main risk to SingTel’s earnings, given that it derives a significant portion of its earnings from overseas. Optus accounts for nearly 66% of 2Q09 revenue and associates account for 43% of its 2Q09 pre-tax earnings. In its recent 2Q09 results, adverse forex movements led to a 16.8% YoY and 8.9% QoQ fall in net contributions from associates. However, we note that forex impacts can also be positive, should the regional currencies strengthen against the SGD. In any case, SingTel has slashed the guidance for associates from low double-digit growth to lower overall YoY pre-tax contributions, citing slower economic growth in the countries as well as working into the lower guidance from key associates like Telkomsel as well as losses from Warid.
More cautious regional expansion strategy. In view of the more uncertain global economic outlook and the relatively tight credit market, we believe that SingTel may adopt a more cautious approach to its regional expansion strategy. By doing so, we see a higher chance of a special dividend – this was something that SingTel has consistently done in the past to return excess cash to shareholders. However, it is unlikely to be large as SingTel may need to conserve cash for its higher capex spending on the Next Generation National Broadband Network (NBN). It may also need to set aside cash in case Optus is successfully in its bid to build the NBN-equivalent in Australia. Maintain BUY with S$3.09 fair value.