Will iiNet Give TPG Indigestion?

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-Synergies may take time
-Gaining share in corporate
-Strong cash conversion
 

By Eva Brocklehurst

TPG Telecom ((TPM)) has pulled off a strong FY15 result and is now tasked with incorporating the acquisition of iiNet. Departing from usual practice, the company provided no guidance at its result other than to signal organic growth would continue in FY16. This could well be because iiNet is a sizeable chunk and only in the early stages of integration.

Morgans will wait for the AGM in December for an update on how iiNet is tracking as it is too early to judge the synergies, or factor it into estimates. This is a key point in the risk/reward equation for TPG shareholders. While iiNet should create value, the broker considers this is implied in the share price already.

Morgans forecasts around $150m in iiNet synergies but expects these will be extracted over a number of years. TPG is a quality business but the broker struggles with the price. Hence, a Reduce rating and $7.55 target.

Synergies with iiNet may take time to be realised, maybe up to five years, but should not be underestimated, in Citi's opinion. The company added 39,000 broadband customers in the second half and the composition of these additions is shifting towards the National Broadband Network. There were incremental gains in voice bundles and the company appears readily able to gain customers at a higher revenue per unit contribution. All favourable trends, Citi maintains.

All up, TPG is enjoying robust revenue and earnings growth, underpinned by market share gains and infrastructure synergies to be had. Corporate momentum is strong. TPG flags, on a pro-forma basis, AAPT accounted for almost half of the additional $83.3m in earnings achieved in the corporate division. Nevertheless, Macquarie finds the underlying growth rate hidden in the context of associated synergies from the AAPT acquisition.

Mobiles disappointed the broker at the margin, as TPG rolled out a new 4G wholesale contract. While the mobile business remains under pressure, with earnings down 18.4% in the second half, this is small in the context of the whole business. Macquarie acknowledges mobiles contribute just 3.0% to group earnings.

Macquarie downgrades to Neutral as the stock has performed well recently and the valuation has become a challenge. A favourable decision on wholesale pricing from the Australian Competition and Consumer Commission could add another 10-20c per share but the near term upside is still limited, the broker asserts.

Cash conversion was strong at 102% for FY15, while capital expenditure was ahead of guidance at $153m. FY16 capex will remain elevated, Macquarie notes, as it will include spending on both TPG's business and iiNet as well as a revamp of the Glebe office. The broker forecasts $250m in capex in FY16 as the company continues to build out its infrastructure as well.

TPG is Morgan Stanley's number one pick in the telco sector. The company has an advantage in vertical integration and the broker expects it to win more corporate market share. The broker's attention has been snared by the fact the company delivered $60m in incremental organic revenue ex AAPT, which in the broker's survey suggest TPG is now taking market share in the corporate segment.

Morgan Stanley conducted its AlphaWise survey of over 200 businesses in Australia and the data suggest TPG is well positioned. With a more price sensitive environment, which leads to lower customer loyalty, this paves the way for TPG to gain market share.

The broker expects TPG to generate FY15-18 compound earnings growth of 22%, a 64% premium to the sector. If the ACCC proceeds with its current 10% reduction in Telstra's ((TLS)) regulated fixed product, this could add $30m to TPG's FY16 earnings.

The company's fibre-to-the-building network should provide a significant competitive cost advantage and life earnings margins over time as well as additional market share. This is why Morgan Stanley has an Overweight rating on the stock.

There are two Buy ratings, two Hold and one Sell (Morgans) on FNArena's database. The consensus target is $10.01, suggesting 4.8% downside to the last share price.
 

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