A weaker 3Q?

Potential disappointment in 3Q

Earnings disappointment. We expect StarHub to report 3Q results (Wed, Nov 5th) that will disappoint both the market as well as our own forecasts. As was the case with M1, the lingering after-effects of MNP could dampen margins and cause an earnings disappointment. For 3Q, we project net profit growth of 0-5% qoq but a decline of – 17% to -21% yoy. Revenue should remain relatively flat qoq but gently climb upwards by 4% yoy. EBITDA margins in 3Q should come in at a range of 27.6-28% which would be a similar level to 2Q08 margins of 27.6% or slightly better.

MNP after-effects, not as significant as other two competitors. The after-effects of MNP will be a key theme in the quarter with attention particularly focused on subscriber acquisition and retention cost (SARC). Unlike its other two main rivals, our view is that StarHub will be less affected relative to the two. It does not offer iPhones at the current moment (though it will by year end) which allows it to save on further subsidies. Also, it has not been as aggressive as M1 in offering promotional activities (e.g, free 6 month subscription for users migrating from other operators, multi-line savers and per-second billings). The investment quarter in 2Q should herald a bottom in margins in 2Q and downside risk to margins should be limited in 3Q.

Tougher operating landscape. Singapore’s advance 3Q GDP numbers showed that it has gone into a technical recession. The government lowered its 2008 GDP forecast to around 3% from 4-5% versus our own forecast of 2.5% for the year. In the last few months, StarHub has voiced concerns over a cutback in spending on telecom services just as SingTel issued similar pronouncements as well. That said, StarHub was still sticking to its 7% yoy revenue growth for 2008 vs our own at 6%.

Expect a 4.5 cts dividend. On the dividend front, we expect another 4.5 cts for 3Q, consistent with the minimum 18cts guidance for FY08 and we do not expect substantial payouts or special dividends. This is predicated on the need to conserve cash for an expensive content battle in 1HCY09 and until the outcome of OpCo is known in 1QCY09. This would bring the total dividend declared to 13.5 cts.

Prepaid and fixed broadband less competitive. Competition remains hypercompetitive in prepaid but should have eased off slightly. We believe that prepaid ARPU is likely to have hit the bottom in 2Q. Similarly, although StarHub has lowered its rates in fixed broadband to match M1’s entry, competition has been fairly rational as competitors have not reacted in kind.

Mobile broadband, a more keen battleground. In the last few weekends, StarHub announced that it would upgrade speeds on its HSPA platform to 5.76 Mbps from 1.9 Mbps for uplink speed by end Dec while downlink speeds will be upgraded to 21 Mbps from 14.4 Mbps by end 2Q09. This ups the ante on mobile broadband in the sector where heavy promotional activities and discounting have been characterising this segment.

Valuation and recommendation

Maintain earnings forecast, target price and UNDERPERFORM. While 3Q earnings could disappoint, we make no adjustments to our numbers currently but will likely make downward revisions once 3Q numbers are released. Our numbers for FY08 are already conservative and below consensus forecasts. Our target price stays at S$2.30 (unchanged WACC of 7.5%) but changes to the target price will be made once 3Q results are announced as we roll forward our valuation horizon by a year. We maintain UNDERPERFORM on de-rating catalysts of concerns over weaker-thanexpected revenue and the spiralling cost of content, particularly that of football. We advocate a switch into M1 for less risk to earnings and cash flow and attractive dividend yield of 10.5%.

Negatives priced in

Story: The recent sharp decline in the stock prices have brought Starhub valuations to a more reasonable level given its stable earnings outlook and attractive 8% dividend yield. Margin pressure in broadband and cable TV is a concern, but that would be mainly felt in FY10 and is adequately captured in our below-consensus earnings estimates.

Point: We have three key points to highlight here.

(i) Competitive intensity to ease with SingTel signaling cost cutting. Competition seems to have eased, based on lower handset subsidies, which have come down from peak of about S$300 per handset in 1H08 to about S$100-150 currently. StarHub had won a handsome share of post-paid mobile subscribers in 2Q08. This should benefit the company over the next two years due to its policy of expensing handset subsidies in the same quarter rather than amortizing over a two-year contract period. Recently SingTel’s Singapore CEO Mr. Allen Lew said SingTel would freeze headcount and cut marketing expenses to focus on costs savings, which supports our view of easing competition. This may also imply that festive promotions in 4Q08, can be absent this year, leading to better margins.

(ii) StarHub could benefit marginally from price hike by SingTel. StarHub has extended its fixed line service for free to its pay TV customers after SingTel raised its fixed line service charges by c. 14%. Since this is a VoIP phone service, costs are minimal for StarHub, and it will gain from (i) one-time activation fee of close to S$40 (ii) more revenue from its international direct dialing (IDD) service and (iii) higher value proposition for its pay TV business and up-selling of more services.

(iii) Telcos are relatively immune to economic slowdown. Amid a slowing Singapore economy, telecom players like StarHub should continue to report stable earnings as consumers and business continue to spend on communications needs.

Relevance: We peg our target price to 14x average FY08-09F EPS, implying 20% premium to our target PER of 12x for M1, and at the lower end of Starhub’s historical PER range (13.3x-19.4x). Upgrade to HOLD with target price of S$2.50.

Cautious tone

Bloomberg has reported StarHub’s CFO Mr Kwek Buck Chye as saying:

• Its users may scale back spending on telecom services because of credit tightening on corporate and small business customers, although he believes that consumers “will still use our services but less”. Despite this, StarHub is maintaining its revenue growth guidance of 7% yoy for the year.

• StarHub does not plan to refinance its S$142.9m loan which will be due within 12 months. “It’s not a question of availability for us; it’s a question of whether we want to go ahead and take that risk. I think the better time would be to wait six months to a year.”

Comments

StarHub’s cautious tone does not surprise us and is consistent with our negative view on the company. Also, by planning to repay the S$143m loan, we believe the chances of a special dividend or capital repayment are significantly reduced. StarHub had cash of S$102m and debt of S$828m as at 2Q08. When we downgraded our rating on StarHub to Underperform on 5 Sep 08, we highlighted, among other things, that: 1) consumers may downtrade on its services due to higher costs of living; and 2) StarHub may not undertake capital management in FY08 given a fairly high gearing of 1.41x , slightly below its long-term target of 1.5-2.0x.

Mr Kwek’s statements came on the back of SingTel’s recent comment that: “The tea leaves are indicating that things are going to be very uncertain” and it will “start to curtail some of our unnecessary spending and be a bit more cautious.”

Valuation and recommendation

Maintain UNDERPERFORM, with a DCF-based target price of S$2.30 (WACC 7.5%, terminal growth 1.7%). De-rating catalysts could include rising concerns over weaker-than-expected revenue, and the cost of content, in particular that of football.

As we head towards year-end, we expect investor attention to turn to events in 2009, and focus on the bidding war for the rights of both the World Cup and BPL in mid- 2009. We prefer MobileOne (M1 SP, Neutral, target price S$2.05) for its more visible earnings and attractive dividend yields of 8%.