Morningstar Best Ideas List: An undervalued play in telecom

-- | 11/05/2022

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Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport, today joining us is Brian Han. He is an analyst in our equity research team. Brian, thanks for joining us.

Brian Han: Thank you.

Rapaport: So we're here today to diverse the Morningstar Best Ideas list. And you've put a stock on there a long time ago, but we're going to talk about it today, because you've come out with a new special report. So we're going to talk about TPG, and why you think it's the best idea. I want to go back just a couple of years the stock really hasn't seen that sort of post pandemic bounce that a lot of other stocks have. Can you talk to me about why this stock has been lagging? What are the sort of issues going on? And why doesn't the market have a lot of faith in this stock?

Han: Yeah, firstly, I think it's because the market always prefers to see the (whites) of the recovery before they invest. And I must admit, the recovery signs have been quite slow to come through in terms of subscribers and in terms of earnings. But as we do always at Morningstar, we look forward and the forward indicators to us are looking very good. And if you don't mind if we start the investment thesis. From the very first beginning, there have been two areas where TPG has been haemorrhaging earnings. One is COVID, as you said, they've lost about $120 million over the past couple of years due to COVID, the border closures, the restrictions on movements.

Rapaport: And is that primarily due to sort of customers that they have?

Han: Exactly. So we're talking about migrants, students, and travellers. And those are segments where TPG has a pretty big weighting in, so they have been disproportionately impacted by all these COVID restrictions. So that's $120 million that they lost over the past two years due to those factors. Another thing is just over the past two years, again $120 million has been lost to NBN. Because they were forced to migrate their own broadband customers on their own network to the NBN. So that cost them another $120 million. And the good thing is, these two areas, we think the earnings declines have bottomed because, first of all, on the NBN, I think they only have about $30 million of profit to lose. So I think we're bottoming out there.

And in terms of COVID, as you know, I think life is going back slowly towards normal. And in fact, in the most recent March quarter, this company actually added about 70,000 subscribers. So that's first time increase in about six consecutive quarters of decline. So that's a good sign too. So you have two areas that have been haemorrhaging earnings sort of bottoming. And then now we can actually look forward to underlying earnings growth coming through for TPG. And there are several sources of that underlying earnings growth.

Rapaport: Just before we get to that I just want to ask you about the merger that happened with Vodafone. Has the company seen any cost savings or synergies from that happening over the last year or so?

Han: Yeah, so one of the sources of that underlying earnings growth is their synergy. So these two companies and when I say two companies, I mean TPG Telecom and Vodafone Australia, they merged. I think the completion of that merger was in mid-2020. And the cost savings have been coming through so much so that by the end of this year these two companies should generate about $150 million in synergies and cost savings. So that's one of the major sources of earnings growth that's coming through. But then, if we look at, for instance, the mobile market, just focusing on the mobile market. Since 2017, our mobile industry has gone through unprecedented mobile discounting. Everybody was chasing subscribers and market share at the expense of profitability.

Rapaport: So if I showed up and tried to get a mobile plan, everyone was competing for the lowest price.

Han: Exactly. And the worst thing is, you didn't even have to go and ask because somebody will do a major deal and then the rest of them will follow and before you know it, you can get a better deal elsewhere. So we had that for about four years since 2017. But that is now normalising, and the reason why it's normalising is because number one, the market leader Telstra finally said as a market leader, we are going to show that leadership and we are going to hold tight and that had a cascading effect on the rest of the market. And the second thing is there is an operator, there is a CEO who used to run TPG, who was renowned aggressor in terms of discounting. His name was David Teoh and he's now out of the picture. So that also had a stabilising impact.

But the most important thing is, and this happens in every transition from 1G to the next. So as we transition from the current 4G to 5G, that also introduces rationality, simply because all these operators spent a lot of money building up the 5G infrastructure. And now, they want a return on that investment. So that will make the mobile market more rational. And in fact, there is already evidence coming through that rationality is returning. Telstra's mobile margins are improving (out of sight). Optus' average revenue per user is increasing very rapidly. And also TPG itself, as I said before, they are now gaining subscribers at reasonable prices.

Rapaport: So at this point, you don't think that the market has really recognised all these forces that you're talking about and push it across to the share price.

Han: Exactly. Because I think one thing is that there is a lot of market interruption in terms of the rising bond yields, and also rising interest and what that means for spending. So there's a lot of friction in the market. And in a recovery story like this, I think people say we want to see actual evidence of recovery before we invest in it. And we think we're smart enough to time our run just before the recovery really happens. Whereas we always look long term out, and we can see the recovery in two to three years time, and now is probably the time to buy it because the market has not recognised those recovery potential.

Rapaport: Just to play devil's advocate quickly, are there anything that you're concerned about, any sort of things that can go wrong here in your thesis?

Han: Yeah, I think the key thing is if somebody blinks and then starts discounting again, for whatever reason, one reason could be they might look at Telstra's leadership in 5G and 5G subscriber signups and they'll go, we're falling really behind. Why don't we cut prices and try to stem this market share losses to Telstra? And that will again have a cascading impact on the other two operators. So that's probably the key thing that I am worried about that will have a resurgence of price discounting. But apart from that though, I think the general increase in the interest rate, I think that will have a big impact on not just TPG securities, but the whole stock market because the price of money is going up. And I hate to say this as a fundamental analyst. But I don't think I am saying anything controversial in saying that falling interest rates has arguably been the single biggest driver of the stock market over the past decade or two. And now we're in an environment where those interest rates are going up. And that's going to have a very, very big disruption in the whole market. And that may obviously hurt.

Rapaport: Is it fair to say that broadband is an essential these days, you can't live without broadband services or mobile?

Han: Well, certainly, if you talk to my kids and my wife, they'll say they can't live without them. And certainly in this age of working from home it would be a challenge to be without broadband and mobile. Well, forget about it. I don't think anybody can live without mobile these days. So it has become an essential spending, and perhaps it will get swept up in that inflationary environment which would be good for this industry.

Rapaport: Right. And thank you very much for joining us and sharing your thoughts.

Han: Thank you, Emma.

This report appeared on 2022 Morningstar Australasia Pty Limited

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