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Sky, Telstra top picks in telco space

Glenn Freeman  |  10 Oct 2019Text size  Decrease  Increase  |  
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As the rollout of Australia's National Broadband Network continues, Australian telecommunication companies face stiff headwinds, but some are better positioned than others.

Retail investor darling Telstra (ASX: TLS) is wearing the biggest impact of the NBN, which is blowing a $3 billion earnings hole in the major telco's margins.

But Telstra is in the midst of a transformation program, cutting jobs and streamlining its operations to ward off competition and build its capabilities in 5G. And the market is responding, Telstra's share price having gained some 38 per cent this year.

The narrow-moat-rated group remains one of Morningstar Australia's best stock ideas, currently trading at a 13 per cent discount to senior equity analyst Brian Han’s fair value estimate of $4.40.

"Investors are preoccupied with a number of risks facing the group. First, competition is intense in Australian telecom across all segments.

"However, we believe Telstra boasts the strength to compete, given a sustainable cost advantage from unrivalled scale, its infrastructure footprint, and consistent capital spending to maintain this competitive edge," Han says.

Telstra’s dividend payout ratio stands at 4.2 per cent fully franked, down from a lofty 6.3 per cent in 2017, but nevertheless attractive in a low-yield climate.

Han forecasts Telstra will replace more than $2 billion of the NBN-inflicted earnings hole, mostly through "self-help measures" of cost cuts and productivity gains.

"We think our revised dividend estimates are sustainable, providing investors with an attractive 4 per cent fully franked yield at current prices, especially with a conservative leverage ratio of less than 2 times.

"This provides Telstra with sufficient financial flexibility to fight for and retain customers in the current competitive telecom environment," Han says.

Sky ranks among most undervalued stocks

Though it doesn't warrant a Morningstar moat, Sky Network Television (ASX: SKT) remains one of the most undervalued Australian stocks within Morningstar's research universe. Sky's last closing price of 85 cents is a 50 per cent discount to Morningstar's $1.70 fair value estimate.

This is despite Han having cut his fair value estimate by 8 per cent at the start of October, in response to the pay television provider's purchase of sports streaming business, RugbyPass.

"Investors have no shortage of ammunition to disparage Sky's investment case, including unrelenting structural pressures on its satellite pay-TV unit, question marks over its ability to compete against the streaming onslaught and the risk of losing key content rights.

"These are valid concerns. But they are also why Sky's stock price has slumped almost 80 per cent in the past three years," Han says.

But he believes the market is ignoring several encouraging signs, including:

  • A subscriber base that is nearing an inflexion point
  • New management's commitment to streaming within the broader business plan
  • Investment in compelling content and key sports rights.

Sky saw a net gain of 11,000 subscribers in fiscal 2019 – its first lift in three years, as a loss in satellite subscribers was offset by 54,000 new streaming subscribers.

Han is also encouraged by clear signs that Sky's new management is moving away from its legacy set top box business in favour subscription video on demand – further evidenced by the latest acquisition.

"The launch of Sky Sport NOW demonstrates the new management is moving much faster on the SVOD front.

"It is prepared to transition the group to a brave new world of much lower EBITDA margins of around 20 per from the current 30 per cent level," he says.

Dual-listed mobile operator

Spark New Zealand (ASX: SPK) is the largest telco in New Zealand, and is also listed on the Australian Securities Exchange.

Its scale underpins Morningstar's narrow economic moat rating, given Spark's dominant market share across all segments of the New Zealand telecommunications space gives it a considerable cost advantage.

Spark generates more than one-third of group revenue from its mobile network, which has steadily grown its subscriber base to more than 2.4 million, from 2 million in 2012.

Han lifted is earnings estimates by around 4 per cent after management delivered its fiscal 2019 results in August.

He notes that the share price shot up about 7 per cent beyond his fair value estimate in August, "buoyed by Spark's resilience amid current market uncertainties" but questions the sustainability of share prices of around the $4.20 mark.

"Whether such a premium can be sustained is likely to hinge on the details of new CEO Jolie Hodson's new three-year strategic plan to be unveiled early 2020.

"After all, there remains pressure on revenue, which was flat in fiscal 2019, with Voice continuing to be a serious drag, down 15 per cent," Han says.

He believes the quality of Hodson's plans will determine whether Spark remains a dependable yield stock, or whether it becomes a higher risk stock with a bias toward growth.

Spark's last closing price of $4.32 places the stock at a 14 per cent premium to Morningstar's $3.70 fair value estimate.

Investor caution urged

Another New Zealand-based business that is also listed in Australia, Chorus (ASX: CNU) holds a near-monopoly in New Zealand's fixed-line telephony and broadband markets.

Though the firm's share price was trading around 17 per cent above Morningstar's $4.10 fair value estimate after the fiscal 2019 results were handed down in August, Han urged investors to be cautious.

"The regulatory framework for governing Chorus' fibre network is still not yet set, and critical parameters such as cost of capital, asset valuation, and cost allocation remain subject to conjecture until November 2019 and beyond.

"Furthermore, the potential impact of 5G-backed structural challenges to its fixed-line infrastructure remains a wildcard," Han says.

He also points to the surprise announcement of CEO Kate McKenzie's decision to step down at the end of this year.

Corporate focus, infrastructure strength

Rounding out this list, Vocus (ASX: VOC) is a telecommunications company squarely focused on corporate and government customers.

It owns an extensive fibre and data centre network that has been built up over a number of years, both organically and through acquisitions.

This infrastructure network is its key asset, consisting of some 2,000 kilometres of fibre in nine metropolitan cities in Australia and 5,000 kilometres in New Zealand.

"This asset is difficult to replicate for new entrants, both financially and practically. It is the ownership of this fibre infrastructure that furnishes Vocus with a narrow moat due to cost advantages," Han says.

Connecting more than 5,500 commercial buildings in Australia, Vocus has a return on invested capital of 20 per cent, with attractive economics enabling management to fend off potential new competitors.

"However, the group has been beset by integration and execution risks, leading to a string of board and management changes," Han says.

"The NBN regime also poses a risk to Vocus' consumer-facing business."
With a fair value estimate of $3, Vocus' last closing price was $3.35.

TPG tangos with the ACCC

Another narrow moat stock, TPG Telecom (ASX: TPM) has been in the headlines in more recent times because of the competition regulator's attempt to block its planned merger with competitor Vodafone.

This was an attempt by TPG to escape what Morningstar's Han describes as the "NBN's margin-crunching impact" by entering the mobile market space.

A final decision on the appeal against the Australian Competition and Consumer Commission's decision, launched in mid-September, is expected in February. But TPG's current share price, which last closed at $6.93, "appropriately reflects TPG's value as a stand-alone entity," Han says.

In fiscal 2019, the telco's net profit after tax but before amortisation fell 13 per cent to $376 million.

"The angst caused by the NBN in the consumer segment could have been much worse if not for management's efforts on the cost front," says Han, noting that overhead expenses were cut by 7 per cent in the last financial year.

"However, there is only so much more blood can be squeezed from this rock," Han says.

is senior editor for Morningstar Australia

Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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