The share price carnage in the telco sector this year has investors asking if there is attractive value in the major stocks Telstra, TPG Telecom and Vocus or if the sector is impaired and should be avoided. Unfortunately we remain sufficiently concerned about Telstra and Vocus that neither is likely to join our model portfolio for the time being. TPG is more interesting and we like the stock below $8.
Doubts about Vocus governance and strategy
The best case here is transitory growing pains; the worst case is the wheels have fallen off. Vocus recently downgraded its 2017 earnings outlook and expected the result to be skewed to the second half. This is the first resort for a company downgrading its outlook and hoping for good luck. The next outcome is usually a further downgrade with deferral of the hoped-for turnaround until the next year.
The departure of Vocus founder James Spenceley and fellow director Tony Grist from the board was controversial. The 2016 results were strong but after last month’s downgrade there do now have to be questions about whether Vocus is effectively governed and managed. The downgrade reflects poor operational execution, an inability to translate costs into revenue and what seems to be a failure of due diligence before acquiring Nextgen. Vocus only announced the acquisition of Nextgen five months ago and raised equity funding between $7.55 and $8.50; the stock is now trading at half this level. If over this short period Nextgen has already lost customers, had lower new sales than expected and had to re-sign contracts at lower margins, and these disappointments were not foreseen during the due diligence and when the equity raising prices were set, then the DD process failed and the board’s risk committee missed this.
An apparent slowdown in corporate revenue is also concerning as this segment had provided the strongest growth and was supposed to offset margin compression in NBN resale. Management claimed the corporate business is meeting expectations but this is hard to reconcile with falling monthly recurring revenue. Sales growth has slowed, which could point to staffing/culture problems in the business.
More broadly the corporate strategy seems flawed and buying the stock now requires a large leap of faith. The downgrade draws attention to Spenceley’s and Grist’s concerns before they left the board. We always thought the simultaneous integration of four large acquisitions (iPrimus, M2, Amcom and Nextgen) was high-risk and possibly too hard.
Can Telstra sustain its dividend?
Telstra could be Australia’s most widely held dividend stock, making the future of the 31-cent dividend crucial to the stock’s rating in the market, but one reason our model portfolio exited Telstra at $5.50 in August was doubt the dividend is sustainable. The week earlier Telstra surprised and disappointed the market by announcing new defensive capex of $300 million to support market share. Our base case is Telstra can sustain a flat 31-cent dividend as long as capex does not escalate too much further, mobile momentum sustains and Telstra can fill the $2-3 billion earnings gap created by the loss of legacy high-margin revenues (fixed voice, ADSL resale).
Our base case is the dividend holds, but the risks have risen.
TPG Telecom’s attractive diversification away from the NBN
TPG’s September guidance downgrade shocked the market but so far TPG’s problems are not the result of poor operational execution or strategic failure.
TPG is the most appealing of the three telco leaders and the stock we are most likely to buy for our model portfolio. We particularly like TPG’s low costs and its fibre-to-the-basement (FTTB) business, which diversifies the firm away from the commoditised NBN resale market. FTTB will be high-margin for TPG but should also be cheaper and more reliable for subscribers, so shareholders should over time see faster value growth than if TPG were just another NBN reseller.
TPG’s bid for 700MHz wireless spectrum is the first move in another plan to reduce vulnerability to price competition in the commoditised NBN and mobile segments. The plan will be to bundle a high-quality national mobile product with FTTB or NBN and the Fetch pay TV service. This should make the customer base stickier and more amenable to higher prices.
The bid for spectrum in Singapore is only in its infancy but any future business here could further diversify TPG away from Australia’s NBN.
Elsewhere, we like the plan to resell FTTB to other carriers and to build and operate private fibre for Vodafone, which can also be marketed to other corporate customers. This should be high-margin.
Clearly the telco sector’s best future profit margins will derive from owning private fibre and not having to resell the NBN. The high upfront price in Vocus’s case was rushed, failed due diligence on Nextgen, overpayment for the acquisition and, we suspect, the ire of the shareholders burned by paying twice the current share price for new equity to fund the acquisition.
The upfront price for TPG is elevated growth capex. We also see at least a 50% chance of an equity raising in coming years if TPG wants to simultaneously build out its FTTB and corporate fibre networks, also launch in Singapore and sustain the dividend.
Originally published in The Australian, 13th December 2016.