Hit on several fronts

• StarHub’s 1Q10 results were sharply below ours and market expectations with net profit fall of 48% YoY to $43 mil.

• We downgrade rating to SELL and cut Fair Value by 4% to $1.88, as we cut EPS forecasts by 11% in FY10F to 15.7 cents and by 6% in FY11F to 16.9 cents.

• Bottomline was hit mainly by surge in handset subsidies and staff costs. EBITDA margins plunged to 22.5% in 1Q10, from range of 29% to 33% across FY09. Management claims these were one-off effects and guides for 28% for FY10F.

• While equipment sales grew 33% to $30mil in 1Q10, equipment costs spiked 93% to $94mil. This brought subscriber acquisition costs to $122 from $77 in 1Q09 and $106 in 4Q09. Management claims they had taken much of the subsidies upfront starting from 4Q09, as they embarked on an aggressive pursuit of high-end smartphone subscribers. StarHub launched iPhones on 9 December 2009, a lag of 15 months behind first-mover SingTel.

• Staff costs jumped 29% YoY to $68mil, due to a one-off $12mil bonus charge as well as higher temporary headcount. As such, moderation in these costs in subsequent quarters will help recovery in EBITDA margins. In addition, 2H10 will see the effect of lower cost of TV content upon the expiry of Barclays Premier League contract.

• Service revenue grew 4% YoY to $527mil, larged helped by 8% YoY growth in mobile. Subscriber net adds were stronger than rival M1’s – at 9,000/month for postpaid and 10,000/month for prepaid. We revise forecast base up by 2% each year. ARPUs held fairly well; and management expects benefits from an increased smartphone base to filter through from 2H10.

• Pay TV continued to add 2,000 household subscriptions in 1Q10 to 541,000, but revenue was flat YoY as ARPU eroded marginally to $55. But the worst is yet to come from the end of BPL in 2H10 – we are expecting 10% of subscribers to drop out, and ARPU to end at $48 for FY10F and $43 for FY11F.

• Competition ahead of NGNBN launch continues to take its toll on cable broadband. With increased discounts and shift in mix to more lower value plans, StarHub added 8,000 subscribers in 1Q10. However, erosion in ARPU to $48 led revenue fall of 5% YoY.

• Wholly-owned Nucleus Connect (wholesale operator in NGNBN) will launch commercial service in 3Q10. Buy we think it is early days to expect a big impact in the near term as the addressable coverage is only about 20%. All in, Management is guiding for low single digit topline growth for FY10F.

• Despite a challenging year ahead, Management expects to maintain DPS of 5 cents per quarter. This puts current yield at attractive 9% p.a. However, with payout ratio exceeding 100% and projected Net Debt/EBITDA rising to 1.5x in FY11F, we feel maintaining DPS will be threatened. With 20% share price downside till FV, yield will be wiped out.

The iPhones strike back

• Below expectations; maintain Underperform. Excluding a one-off staff bonus of S$12m, 1Q10 core profit was below expectation at 19% of our FY10 forecast and 18% of consensus. The variance arose from higher handset subsidies (mainly iPhones). As expected, a 5ct DPS was declared. We cut our FY10 and FY12 core net profit estimates by 3-15% to reflect iPhone/smartphone subsidies, partially offset by higher ARPUs from smartphones. Our FY11 core net profit rises by 2% as higher ARPUs should start to offset margin hits over the life of the phones' 2-year contracts. Our DCF-based target price of S$2.14 (WACC 9.7%) is unchanged.

StarHub remains an UNDERPERFORM on concerns over pressure on broadband ARPUs from the launch of NGNBN, and heavier handset subsidies. We are also disappointed that it has discontinued disclosure of segmental margins. Switch to M1 which offers greater capital-management potential and growth, in our assessment.

• Revenue inched up. Revenue improved 1% qoq with the help of all divisions save pay TV. Postpaid revenue (+2% qoq) was driven by strong net adds of 27K as StarHub aggressively pushed iPhones (launched on 9 Dec 09). Broadband revenue was flat as strong net adds were overshadowed by weaker ARPUs from discounts and a shift to lower-tier plans as StarHub penetrated new market segments. Pay TV (-1% qoq) declined as a higher subscriber base was offset by lower ARPUs from heavier discounting.

• iPhones struck back. EBITDA margins (-3.3% pts qoq) dived from higher handset subsidies (+17% qoq), content costs (+7% qoq) and staff costs (+13% qoq excluding one-off bonuses). Thanks to a full quarter's worth of iPhone sales, handset costs accounted for 17% of revenue in 1Q10 from 15% in 4Q09. M1 was similarly affected by iPhone subsidies as its EBITDA margins shrank 5.7% pts qoq. Content costs rose as StarHub renewed more content and acquired some new ones. Finally, staff costs rose from higher salaries as competition for talent heated up on the back of a rapid economic recovery and lower Jobs Credit grants. Higher handset subsidies also forced StarHub to lower its service EBITDA margin guidance to 28% for FY10 from 30% before.

• No capital management. Despite a fall in net debt/annualised EBITDA to 1.05x in 1Q10 which remained below its target of 1.5-2.0x, StarHub will not be undertaking any capital management in FY10.

Higher phone subsidies pull StarHub Q1 profit down

But telco expects better earnings later, with higher ARPU of smart phones

STARHUB'S first-quarter net profit was almost halved from a year ago as its cost base skyrocketed after taking a bite at the Apple iPhone and other Web-enabled handsets.

The operator yesterday reported a net profit of $42.7 million, a 48.3 per cent drop from $82.5 million last year when the global recession was in full swing.

Earnings per share for the three months ended March 31 was correspondingly slashed to 2.49 cents, from 4.82 cents a year earlier. StarHub's Q1 operating revenue rose 5 per cent to $557.2 million.

'It's been quite a challenging quarter,' said StarHub CEO Neil Montefiore in a conference call yesterday.

Despite the bottom-line decline, the operator is keeping to its promise of paying shareholders at least 20 cents this year. It has proposed an interim dividend of five cents per share, up from 4.5 cents a year earlier.

StarHub's Q1 profitability was dented by an increase in its operating costs due to higher subsidies for smart phones such as the iPhone.

The firm's cost of sales climbed 26 per cent to $249.2 million in the first quarter.

This was because its cost of equipment nearly doubled to $93.8 million as a result of heavy handset subsidies, particularly for the iPhone. StarHub's operating expenses also grew 11 per cent to $250.3 million due to staff bonus payments and other items such as an increase in its operating lease.

The January-March timeframe marked the first full quarter since StarHub introduced the iPhone last December alongside rival M1.

Singapore Telecommunications got its hands on Apple's handset a year earlier. M1 and SingTel's profitability took a similar hit shortly after their iPhone debut.

Instead of subsiding after the first month, the iPhone fever continued to rage on in the first quarter, Mr Montefiore said.

'Three quarters of the phones we sold were smart phones. Subsidies are higher for smart phones,' he added.

StarHub's policy of writing down the full cost of these handsets at the point of sale means its bottom line will take an immediate hit.

Although the smartphone craze is bad on the balance sheet initially, the operator is confident the growing adoption of these Web-enabled handsets will pay off in the longer term.

'Smart phones deliver higher ARPU (average revenue per user) of around $10 more,' he said.

Revenue increased across half its business lines. Sales at StarHub's mobile division, which accounts for 51.4 per cent of its revenue, climbed 8.1 per cent to $286.3 million. Fixed network business revenue edged up 1.1 per cent to $79.9 million.

Broadband sales slid 4.6 per cent to $59.5 million, while its cable television sales fell a marginal 0.4 per cent to $101.6 million.

During the quarter, the Media Development Authority (MDA) introduced a controversial policy which has a major impact on local pay-TV providers StarHub and SingTel.

The new cross-carriage mandate forces operators to share any exclusive content they sign from March 12. To stoke the flame even further, the regulator is also looking into a possible leakage of this policy change before it came into effect.

Mr Montefiore said the company has submitted its feedback to the government on the new ruling under an MDA industry consultation exercise which ended yesterday.

StarHub shares closed one cent down yesterday at $2.27.

Engineering The Next Phase Of Growth

Leveraging on level playing field in corporate data. StarHub’s limited reach in corporate data services is set to enlarge thirty folds starting Jun 10. The telco is able to service 26,000 commercial buildings island-wide riding on network infrastructure provided by Next Gen Nationwide Broadband Network (NGNBN), versus only 800 within the CBD now. Prospects are further enhanced by the government’s decision to utilise NGNBN for the bulk of its requirement for telecoms services. Hence, this business will expand to 20.8% of service revenue in 2012.

Growth in mobile data traffic enhances ARPU. The launch of Apple iPhone has made smartphones indispensible. 75% of mobile phones sold at StarHub Shops were smartphones in 4Q09. The proportion will expand following the launch of seven new models based on Android, BlackBerry, Symbian and Windows Mobile in 1Q10. Mobile service plans bundled with data are priced at about S$10 above those without data. Thus, we expect post-paid ARPU to increase 6.2% over the next two years.

Pay-TV business faces less risk from cost escalation. Media Development Authority’s (MDA) latest ruling requiring cross carriage of exclusive content is now enshrined in Media Market Conduct Code. Pay-TV operators could henceforth acquire content on a non-exclusive basis or collaborate to jointly bid for content. Cross carriage of exclusive content will result in lower cost of content but reduces differentiation between content provided by StarHub Cable Vision (SCV) and mio TV over time.

Initiate coverage with BUY. StarHub’s valuation is attractive with 2010F EV/EBITDA at 7.6x, compared to 10.3x for SingTel. We estimate 2011 free cash flow at S$0.22/share, representing free cash flow yield of 9.3%. The stock provides a rich dividend yield of 8.4% for 2010-11. Our DCF valuation for StarHub is S$2.92 (required rate of return: 8.5%, terminal growth: 0%).