Small Telco Players In Focus

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– Stockbrokers see robust outlook for smaller telcos
– Sector delivers earnings certainty
– Citi initiates coverage on iiNet and TPG
– Macquarie initiates coverage on M2

By Eva Brocklehurst

As the telecommunications sector continues to show robust growth, Citi has initiated coverage of two stocks, iiNet ((IIN)) and TPG Telecom ((TPM)). Macquarie, also, has initiated coverage of M2 Telecommunications ((MTU)).

Cit has placed a Buy rating on IIN and a Hold for TPG. Why is IIN preferred? Citi says subscriber growth is slowing in the broadband market and this puts the focus on margin. With regulatory changes happening in February 2013 in wholesale ADSL pricing this could mean higher gross margins and a need for cost rationalisation. Citi believes IIN is better placed in this respect. Nevertheless, revenue growth from mobile and small-medium business segment is set to continue for both carriers. In the case of both stocks the robust share price performance has been supported by earnings growth, from a mix of organic growth and acquisitions. Citi expects there's more of this to come and this would deliver material share price upside, particularly for IIN.

Citi notes valuations are hardly stretched for either stock, with IIN trading on a price/earnings ratio of 10 times and TPG on 13 times estimated FY14 earnings. The broker believes both stocks have earnings growth potential over the next three years. The target price for IIN is $5.01. As subscriber growth stagnates the focus turns to lifting margins from cost savings and new products. Citi sees significant option value in the medium-term, from the National Broadband Network roll out, industry consolidation and cash returns and these have not been presumed in its forecasts. At these levels IIN's valuation remains attractive despite the recent share price outperformance. Citi sees the potential loss of broadband subscribers as the primary risk to its rating on IIN. Also, the potential revenue impact could derail the earnings growth opportunities from regulatory price changes, cost efficiencies and medium-term market share gains.

TPG, should benefit similarly but it has offsetting factors, limiting the upside. What are these? Citi's concerns centre on margin compression and valuation. TPG can still benefit from medium term drivers but with less earnings leverage. For TPG, Citi's target is $2.30. The broker sees TPG as a business which is delivering subscriber growth with good earnings margins and solid balance sheet. On the risk side, Citi cannot rule out increased competition from incumbent operators Telstra ((TLS)) and SingTel's ((SGT)) Optus, and/or new entrants like Foxtel or utility companies. However, this is not new, Citi notes these smaller telcos have been competing with incumbents and new entrants for nearly two decades.

What do other brokers on the FNArena database consider the triggers for these stocks? After IIN reported strong full year earnings back in August several brokers changed ratings, but not in the same direction. Deutsche Bank downgraded to Hold as it saw the stock trading around its valuation, even allowing for the potential to gain scale and cut costs. CIMB, however, moved IIN to a Buy, citing earnings that beat its forecasts. IIN has a consensus target price of $3.93 with a range of $3.50 to $3.93, excluding Citi's outlier at $5.01. IIN counts five Buys, a Hold and a Sell (Credit Suisse). Credit Suisse finds the stock trading above its target price and considers subscriber growth subdued. For TPG there are three Buys, Citi's Hold and a Sell (CIMB). CIMB downgraded the stock to Sell after the company's latest results. The broker could not see the earnings growth reflected in the premium being traded to the sector. The consensus target price is $2.19 from a range of $2.15 to $2.40.

Meanwhile, Macquarie has initiated coverage of M2 Telecommunications ((MTU)) with an Buy recommendation and $4.21 price target. M2 is the largest Australian independent telecommunications network reseller and targets both small and medium sized businesses in Australia/NZ via its Commander brand. The company provides fixed-line, mobile, data (wireless & fixed) and hosting services to both small-medium businesses, wholesale and residential customers by taking advantage of excess capacity available on other telecommunications carrier network infrastructure.

Macquarie finds that the acquisition of Primus Telecom in June 2012 was significant for M2, given the assets acquired (data centres, metro fibre rings, DSLAMS and an IP/Voice hosted solution) and is expected to strengthen M2's position in the NBN through enhanced scale and reach. Macquarie notes management has identified significant potential in combining the two companies in terms of enhanced buying leverage with suppliers, cost base rationalisation and moving customers on-net, which attracts a higher gross margin. Macquarie suspects this will be the key driver of profit growth in the medium term. However, the broker is cautious beyond FY13 as the gains get harder to maintain, given the size of the business and potential for integration issues as well as operating and maintaining telco infrastructure.

Telstra still dominates the market with an estimated 75% of total revenue generated from telecommunications services (and an estimated 80% share of the small business segment). However, Macquarie believes newer entrants, without the encumbrance of network infrastructure, can target specific segments using aggressive and targeted marketing. The broker does sound a note of caution: other than the major carriers, few companies that have attempted to become infrastructure owners have survived independently in the past. Macquarie joins Citi, which initiated coverage of M2 in September, on the FNArena database. Citi has a Buy rating and target price of $4.60. Citi sees upside for M2 with its niche position and synergies from the acquisition of Primus. 

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