Reassessing TPG after deal falls through

TPG Telecom’s (ASX: TPG) shares plunged over 10% on Monday after the company was unable to complete a $6.3b asset sale to Vocus.

Morningstar Director of Equity Research Brian Han is not surprised at the ending of discussion to sell TPG’s non-mobile fibre assets. Han has been circumspect on the prospects of a deal since it was first announced. It was a revelation seemingly only prompted by a media report on Aug. 1, 2023, given the highly conditional and nonbinding nature of the offer.

Han’s reservations were compounded by the prevailing credit and equity market volatility and the complex amalgamation of assets that is TPG's current fixed-line unit which services enterprise, government, and wholesale customers. It appears that complexity was a key obstacle to a transaction, with the parties unable to "reach alignment on the operating model and commercial terms."

To investors, it may be back to square one for narrow-moat-rated TPG Telecom, with "hot money" fleeing. However, that square one has been the basis of Han’s $7.40 per share fair value estimate.

TPG’s sustainable competitive advantage

Han has assigned a narrow economic moat rating to TPG Telecom. The key source for the moat is cost advantage. Cost advantage refers to being able to deliver products and services cheaper than competitors. In TPG’s case the cost advantage stems from the company's infrastructure and network ownership.

This cost advantage is augmented by characteristics of efficient scale in the Australian telecommunications industry, aided by TPG's extensive infrastructure assets. Efficient scale occurs when competitors are reluctant to invest given the size of the potential market. Full ownership and operating control over these "hard-to-replicate" assets allow high margins and returns to TPG, compared with competitors who must pay to access these networks.

The sheer scale of its fibre infrastructure in Australia furnishes TPG with the ability to improve its competitive advantage via technology upgrade, marketing and promotion, and content rights bidding. Any investment spending can be spread over a large customer base, thereby reducing per-subscriber costs and placing TPG in a superior position against competitors.

The capital costs required for a new entrant to replicate even a small part of this infrastructure ownership, scale, and brand power would be prohibitive, especially in a relatively small country such as Australia and in a relatively mature industry such as the Australian telecommunications market with low-single-digit compounded annual growth rate (“CAGR”) over the past five years. Consequently, there are characteristics of efficient scale (mature demand, high sunk costs), with limited opportunity for new entrants to add profitable capacity.

TPG’s fair value

Han’s positive view on the shares at the current price point is underpinned by TPG’s resilient fixed-line unit which reported another 5% increase in gross profits in the recent June half. He also believes we are undergoing a continuing recovery in mobile where TPG reported a market-leading 8% lift in mobile service revenue in the June half.

Mobile drove a 7% increase in June-half consumer earning before interest, taxes, depreciation and amortisation (“EBITDA”) and the 120-basis-point lift in EBITDA margin to 30.3% despite a 2% fall in broadband gross profit. There may be an added windfall in the near term from the recent, highly charged, Optus mobile network outage.

Han concedes market concerns regarding TPG Telecom's balance sheet may resurface, with net debt/EBITDA at 3.1. Han points out that this remains below covenant limits. However, management is still committed to liberating the value of its infrastructure assets and there remains "ongoing strong interest from potential strategic and financial investors in the Company’s fixed infrastructure assets." In the near term, all this may be dismissed by investors disappointed with the "no deal" news. But, in the long term, significant value remains in TPG Telecom shares.