Telstra Signals Game On

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By Eva Brocklehurst

Telstra ((TLS)) has raised the competition heat in the telecommunications sector with its purchase of Adelaide-based ISP Adam Internet, for an undisclosed sum. While only a small acquisition for the giant of the sector, it will make players in the middle tier of the broadband marketplace sit up and take notice, according to brokers. Most see it, with Telstra's stated aim to run Adam as a separate entity, as a bid to challenge Optus ((SGT)),  iiNet ((IIN)) and TPG Telecom ((TPM)). For RBS it  is Telstra's "Jetstar moment", referring to Qantas' ((QAN)) well-founded decision to run a budget airline, Jetstar, along side its premium service. For Deutsche, it reaffirms its view that organic growth in this area is difficult. Credit Suisse sees Adam as Telstra's 'challenger' brand and believes it is a significant change for Telstra and the industry.

The acquisition price was not disclosed but speculation puts it at $50-60 million for around 80-100,000 subscribers. Therefore, the acquisition for Credit Suisse, on an 80,000 subscriber basis, implies an acquisition price of 10-12 times FY12 earnings and $550-$660 per subscriber. Credit Suisse believes the deal won't provoke concerns at the Australian Competition and Consumer Commission, given Adam only has around 1.5% market share. RBS also notes, nationally, it would not be a material reduction in competition. However, Adam could have up to 20-25% of Adelaide subscribers and that may concern the ACCC.

Adam is seen operating as Telstra's low cost online channel but benefiting from the infrastructure and balance sheet of Telstra. Credit Suisse says it is a sound strategic move by Telstra, giving it a lower-cost channel to minimise retail market share loss as the NBN rolls out over time. Nevertheless, there is risk, as Adam needs to gain presence outside its home market and not get bogged down by its big brother's bureaucracy. The broker expects Adam to be positioned as a mid-tier operator going head to head with iiNet and Optus, rather than challenging the lower cost providers TPG and Dodo. The reason for this, Credit Suisse maintains, is that Telstra still has the number one retail broadband business (46% market share) and it would have a lot to lose by leading broadband prices down with the Adam brand. Optus and iiNet hold 18% and 15%, respectively, of the national broadband market share. However, in the metro broadband market, the broker estimates Optus and iiNet collectively hold 45%-50% market share. This, therefore, represents a significant opportunity for Telstra to challenge.

For RBS, while this is a small deal for Telstra, it has some important strategic significance. The broker notes Telstra could have set up its own low-cost brand but it could be difficult to be truly low-cost if it was simply operating within the existing Telstra structure. In its view, Telstra is essentially buying a low-cost 'culture' through this acquisition. Expanding on this theory, RBS says the move could signal a willingness by Telstra to use a range of brands to address different market segments, and it may look at a similar strategy in mobile. Moreover, it may enable Telstra to charge a greater premium for the core brand while retaining market share at the lower end of the consumer market. At 30 June 2012, RBS estimates Telstra has 45.3% market share of broadband subscribers nationally so Adam Internet's estimated 80,000 would represent 1.4% and take Telstra's share to 46.7%. RBS feels the challenge is on for Optus, iiNet and TPG.
 
Deutsche also sees Adam competing against TPG and iiNet and believes, with the compression in margins expected for all companies (except iiNet) under an NBN scenario, scale is likely to be important. With the Australian fixed broadband market reaching its natural saturation point, the broker maintains the fixed market landscape is becoming increasingly competitive and organic growth is difficult to generate. Morgan Stanley notes that industry structure will be key to profitability and long-term returns. While not commenting on this specific acquisition, Morgan Stanley believes a consolidation of the industry is due and would be beneficial. It said mid-sized telecoms have incentive to do this because of the large cost savings that can be achieved when acquiring the smaller firms. The broker says that at the bigger end of the telecommunications market the top four players (Telstra, iiNet, Optus, TPG) control around 80% of subscriber market share and have cemented positions, while there is a long tail of smaller firms that are prime takeover targets. It notes iiNet has acquired seven smaller telecommunication firms over the past nine years, extracting  $36m in annual synergies over this time. TPG has also participated in this consolidation, with three acquisitions over the past five years.
 
For Telstra, Adam is not expected to materially impact on forward earnings forecasts. According to Credit Suisse, Adam generated $49m of revenue in FY12 and $8.5m of earnings, representing an earnings margin of 17% and this was in line with iiNet's FY12 earnings margin. Credit Suisse still prefers TPG as a telco pick, seeing iiNet at risk in the medium term from Telstra's acquisition of Adam. In its view, TPG has a sustainable competitive advantage as a price leader and substantial infrastructure position (metro and international fibre). Telstra has seven Hold recommendations in the FNArena database and one Sell. The consensus target price is $3.79 with the range just $3.50 to $4. Consensusforecast earnings growth is 7.6% for FY13 and 1% for FY14. 
 

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