We just avoided the worst ASX 100 share price fall of the week – and it wasn’t good luck.
TPG Telecom (ASX:TPM) plunged 22% on Tuesday in response to FY17 guidance worse than the market expected. We deliberately didn’t own TPM in the model portfolio. This success demonstrates two aspects of our investing philosophy: guarding retirement savings is important, and avoiding heavily overvalued stocks is central. There is also a lesson about where investors should focus their time and attention.
Figure 1. TPM share price chart
Source: Thomson Reuters Eikon
Priority given to preserving capital
We think three things matter most when it comes to retirement savings:
- Growing retirement savings
- Guarding retirement savings along the way
- Generating sufficient retirement income.
Point 2 is our focus in this note. In share investing, the importance of avoiding permanent loss of capital from owning losers is often overlooked or misunderstood. “Losers” could be defined as stocks which fall heavily because the market fundamentally overestimated profitability and earnings growth, as opposed to stocks which drift lower in line with a falling market. These stocks are just as likely to rally in a rising market, whereas stocks which materially disappoint against expectations typically underperform for some months afterwards and face a long journey back to former share price levels. Often they never regain their former premium rating.
Many investors find their way to enough stocks that appreciate but also own other stocks which fall and erase these gains. Too many Australians then give investing away because their returns are disappointing for the risks assumed and time invested. Earning precipitous losses back requires excellent calls elsewhere or taking on more risk to chase higher returns, and often the time and expertise to do so are not present. All this means the path to satisfactory returns and staying interested in investing is to avoid losers in the first place. This need to research stocks to avoid is often forgotten in the rush to find stocks to buy.
How we avoided TPM
Many times in the investment committee we admired TPM’s profitability and growth, presented below in a chart from the Key Ratios tab in StocksInValue, and discussed buying the stock.
Figure 2. TPM profitability data
Source: StocksInValue, Key Ratios tab
But the premium to intrinsic value was always too great so the risks of owning the stock were too high. We never wanted to be caught holding the stock if something like this week’s disappointment happened, as we knew what the share price reaction would be.
Figure 3. TPM share price vs intrinsic value
Not only did TPM trade at a large premium to our intrinsic valuation, it also entered this week priced at 32 times FY17 consensus earnings. On the ASX this is a super-premium multiple, so we considered TPM priced for perfection. To sustain the rating we thought the stock would have to deliver a flawless FY16 result and FY17 guidance at least as high as market expectations.
FY16 earnings met pre-result expectations. The problem was the FY17 guidance.
Figure 4. TPM FY17 guidance
The EBITDA guidance was a material miss relative to pre-result expectations of around $885m. On the result call, management admitted substantial gross profit margin compression from transitioning ADSL broadband customers to the NBN. The problem is NBN’s high wholesale prices for the data speeds customers want (to stream video content like Netflix) relative to the retail prices households can afford and the prices set in a very competitive market. Competition is intensifying in NBN retail prices at the moment of transition from ADSL. In FY16 iiNet lost 6,000 broadband subscribers to competitors for this reason. TPM acquired iiNet for $1.6bn in September 2016 and raised $300m of new equity to partly fund the deal.
The disappointing FY17 guidance is a sharp adjustment to the NBN retail margins achieved by TPM so far and to the FY17 trajectory the market assumed. Admittedly there were positives for FY17 EBITDA from (1) a strong run-rate for iiNet synergies in the second half; (2) ongoing momentum in corporate sales; (3) the first full-year contribution from iiNet; (4) a full-year contribution from lower copper access pricing and (5) margin uplift from retail ADSL customers shifting to fibre-to-the-basement (non-NBN) plans. But the net effect will be sharp downgrades to consensus FY17 earnings forecasts and subsequent growth rates.
This retail NBN margin compression will be a multi-year problem because the acceleration of the NBN under its corporate plan, will see nine million households ready for service by the end of FY18. Management would not be drawn on the likely benefits of offsets like market share expansion, further synergies from the iiNet’s cost base or the expectation for subscribers moving onto TPM’s own residential high-speed networks. We are left not knowing if the guidance is conservative or hopeful and expect other analysts face the same uncertainty. The current future economics of retail NBN packaging are in flux and harder to understand.
This means not only is future profitability and earnings growth lower than previously understood, there is also more uncertainty about the trajectory. This will subdue the share price for a time until consensus earnings rebase and the dispersion of forecasts narrows.
All this was what we avoided by not paying way over the odds for TPM because we didn’t want the resulting risks. Our process, and our discipline at sticking to it, worked.
TPM remains a well-managed company with growth to come. Our task now is to value the company using realistic subscriber and margin assumptions, and to decide what price to pay for it.