TPG Triggers Interest In New FTTB Plan

This story features TELSTRA GROUP LIMITED. For more info SHARE ANALYSIS: TLS

-FTTB plan looks compelling
-But costs are a concern
-How will competitors respond?
-How will the new govt affect plans?
 

By Eva Brocklehurst

TPG Telecom ((TPM)) has stoked interest and speculation in the wake of its FY13 results and the share price has run hot. It's not because of a strong set of numbers but because the company announced plans to build a Fibre-to-the-Building (FTTB) network to 500,000 units/premises in five capital cities, intending to sustain broadband speeds of 100mb/s. Trials are expected to start later this year.

Citi liked the news. The broker restated a Buy rating. The only one on the FNArena database. Citi thinks it represents an exciting development for the telecom sector, enabling access to faster broadband, albeit there's some uncertainty given the changes to NBN policy that are likely with the incoming federal government. Still, Citi estimates potential for a 38% uplift to net profit at 30% utilisation rates. JP Morgan notes the share price response owes a lot to the case that TPG made for rolling out this FTTB product. It would run off the company's PIPE fibre network and TPG would be able to offer speeds comparable to the fastest tier of NBN, but over its own infrastructure, avoiding NBN charges. Given widespread concerns that the NBN would level the telco playing field and compress TPG's margins, the broker thinks it was logical that the company should stress this opportunity.

The FTTB is a highly compelling offer and potential game changer, in Credit Suisse's opinion. The broker has upgraded cash profit forecasts in FY16 and beyond by 20% to reflect upside from FTTB deployment. Credit Suisse assumes TPG will need to build to around 6,667 buildings. In the broker's estimates it equates to capital spending of $87m over FY14-16. Retail earnings margins on the product is expected to be around 68%. TPG has indicated it may offer wholesale access to its FTTB network at prices that could be competitive to the NBN. Credit Suisse thinks 100,000 subscribers in retail and 50,000 in wholesale are easily achievable. This should add $68m to earnings forecasts from FY16.

Macquarie wants more detail on the deployment costs before getting excited. Given the nature of the project, scale in the building is unlikely to be delivered before FY16. For every $100 in capex required per unit/business connected, TPG would need to generate incremental earnings around $8m to deliver a return in excess of its cost of capital, in the broker's opinion. The company has already identified $10m in earnings uplift from migrating its existing ULLS customer base to the FTTB network. Macquarie acknowledges there is significant scope for retail market share gains and winning over wholesale customers in time.

The margin metrics look very promising JP Morgan admits, but notes TPG would need the incoming government to follow though on a commitment to infrastructure-based competition with NBN Co. Thus, if TPG has this option, so would other players. JP Morgan observed the company downplayed the NBN in its briefing, and wonders just what the level of engagement is in this regard. Does it have a plan? Macquarie noted a mention that the company would use the NBN "strategically". According to JP Morgan the slow pace of the NBN roll-out means that TPG is not missing a major subscriber opportunity. Nonetheless, the potential for TPG to gain market share in an NBN world was one of the bull points advanced for the stock in the past and a lack of clarity on the NBN strategy may become an issue.

CIMB is worried about the additional capital expenditure required to build the FTTB network. The broker has increased capex forecasts but also added to the long-term operating performance. The broker notes the underlying growth rate has slowed and the earnings margin of 37.6% could contract in the brave new NBN world. What was enticing? The investment in network infrastructure continues to provide a competitive advantage while TPG's subscriber momentum remains robust. CIMB observes that, with the FTTB and the investment in submarine cable, TPG can offer an end-to-end service bypassing Telstra ((TLS)) and NBN Co. With such control over the cost structure, the company proposes a 100Mbps service with unlimited downloads for $69.99 per month on a 24 month contract and around $160 in initial charges. It will also offer wholesale service and expects to undercut NBN access charges. CIMB think this would offer a significant competitive advantage in the FTTB footprint area.

CIMB does not expect Telstra will take TPG's latest plans lying down. A response is expected in time from Telstra on the HFC network, which likely overlaps the same areas. This could also have implications for the NBN roll-out and access regulation. The broker expects a Coalition government would applaud private sector investment and may ultimately constrain NBN roll-out in those areas with two or more network suppliers. Its policy is to remove regulatory impediments to the construction and operation of non-NBN access networks.

CIMB believes one of the impediments is the ACCC, which has a stated preference for retail level competition and has opposed integrated full service carriers and carrier competition in the access network. It has adjusted regulatory settings to favour a structurally separated NBN. Management of access regulation does, in CIMB's view, deter network investment and appears to have impeded earlier rival telco infrastructure investment. A return of carrier competition in viable parts of the access market is therefore seen as a positive development for TPG as well as for Telstra, being on-net suppliers able to bypass NBN in part of the market.

As things stand at present the broker thinks it could be negative for Optus ((SGT)), iiNet ((IIN)) and M2 Telecommunications ((MTU)). The two former players have extensive infrastructure and may consider developing their own end-to-end on-net strategies. Optus, for instance, has canvassed a possible fibre repayment option but for access to the NBN.

Where do other concerns regarding TPG's outlook lie? Macquarie noted corporate revenues remained under pressure, falling by 2.3% over FY13 and 7.5% in the second half. The key drivers here have been price deflation for corporate customers, as well as lost wholesale revenue due to wider industry consolidation. Macquarie also put a wet blanket on the 36% dividend increase, noting that the 7.5c for the year represents just 34.1% of free cash flow estimates and a yield of just 1.8%. Mobile margins also fell to 23% from 27% in FY12, largely because of a revised wholesale deal with Optus. Management has indicated mobile will not be a growth driver over the next few years but still needs to be offered.

JP Morgan thinks the recent share buyers are too willing to imply significant value for the direct fibre product. The broker retains an Underweight rating. The consensus target price on the FNArena database is $3.96, which compares with $3.05 ahead of the results. The target suggests 11.3% downside to the last share price. In sum, there are one Buy, three Hold and two Sell ratings. Both Credit Suisse and Macquarie downgraded ratings to Neutral (Hold) in the wake of the announcement, citing the excessive rally in the share price. Targets range from $2.93 (JP Morgan) to $4.80 (Citi).
 

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