TPG Rings Up Strong Subscriber Growth

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-Strong subscriber growth
-Margin risk but earnings compensate
-Potential growth in acquisitions
-Potential capital management

By Eva Brocklehurst

TPG Telecom ((TPM)) pleased the market with first half results showing strong subscriber growth in broadband and mobile. What brokers are really seeking is as to how the company can differentiate itself in the hotly contested telecommunications sector. Dividends and capital management are important too, of course.

Management provided no guidance on dividends but CIMB expects the payout ratio to be similar to FY12, at 37%. The broker previously forecast a payout ratio of 45% but notes management plans to focus on paying down debt. The first half dividend payment was 3.5c.

Going forward, CIMB finds risks in the increased price competition in the fixed broadband market. TPG is up against M2 Telecommunications ((MTU)) and that company's recent acquisition of Dodo Australia, another player in the lower value end. Other risks include those of continued margin pressure in the corporate division and slower revenue growth. Mobile margins declined during the half because of lower pricing. CIMB notes TPG is in the process of negotiating the mobile reselling agreement and there could be a risk to margins as Optus ((SGT)) is reviewing channel partner agreements to improve profitability. Having taken note of risks, the broker still believes TPG has ample balance sheet capability to pursue strategic acquisitions. Nevertheless, at current levels, growth is largely priced in. The broker prefers iiNet ((IIN)) given the higher free cash flow yield, scope for cost cutting and corporate activity.

Goldman Sachs hailed TPG's ability to win share in the consumer and corporate segments without sacrificing profitability. The key issue ahead is capital allocation. Will it be acquisitions? TPG has announced a $10m investment in Cocoon data to develop cloud-based applications. Will it be capital management? Goldman notes the balance sheet potential for such but accepts the company is focused on paying debt. Morgan Stanley finds strong free cash flow places the company in a position to increase the dividend, make a small strategic investment and pay down debt.

The big event ahead, the laying out of the National Broadband Network (NBN), presents both risks and opportunities for TPG in Goldman's opinion. The opportunity exists in the increasing ability to tap into the market with the structural separation of Telstra ((TLS)) and an improved regulatory environment. The risks are in increased competition and margin erosion from higher costs. For Morgan Stanley there is more opportunity for TPG if the NBN is delayed by 18 months. The broker estimates TPG's value could be 7% higher. Why? Extended increases in organic market share of over 1% per annum for an additional two years, with construction delays pushing cost increases down the track.

Morgan Stanley views TPG as a winner in the NBN space but does not factor this into the base case. Still, the broker likes the stock and rates it a Buy for three reasons. These include on-net subscriber migration and organic market share growth as well as the attraction in any delay in the NBN. The third reason is the potential to participate in industry consolidation, i.e. acquisitions. Morgan Stanley believes up to $477m in aggregate value can be achieved in the industry with further consolidation in the small telecom space. This is the broker's point of differentiation for TPG against iiNet.

Macquarie notes the company has something up its sleeve. TPG previously was going strong on internet protocol television (IPTV), flagging delivery of linear channels and video on demand. A year later that's not the priority. Instead there's an important project in the wings with further details to come over the next three to six months. The broker is waiting. Meanwhile, Macquarie likes the free cash flow generation, ongoing consumer broadband growth and scope for acquisitions. Gearing has fallen to $75m and the broker expects the company to be in a net cash position by the end of the year. While management has stayed mum on returning excess capital, the broker notes the possibility of further network investment or acquisition.

TPG offers value for Credit Suisse. The broker likes the defensive 12% earnings growth for the next three years and is looking for management to use the balance sheet potential to unlock significant shareholder value. The broker would not be surprised if the payout ratio was increased. Credit Suisse views the 15% stake in Cocoon as an investment to fund a start-up company and at the same time acquire product development for the core business. TPG has indicated it does not intend to increase its stake. TPG is the broker's preferred stock in the sector.

For Citi, the subscribers are the key and there's healthy growth there. Citi has upgraded the stock to a Buy, viewing earnings growth as outweighing margin risk. Citi believes the business deserves to trade at a premium to its peers. On the FNArena database there are three Buy recommendations and two Hold. The consensus target price is a neat $3.00, suggesting 3.9% upside to the latest share price. The dividend yield on FY13 earnings estimates is 2.7%.

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