This week Guy Carson takes a look at the changing landscape of Australian telcos.
This article was published in The Australian on 11 September 2017.
Falling prices force a rethink of telco stocks
The Telecommunications sector has been the worst performing sector in Australia over the last year with the reality of the National Broadband Network (NBN) taking its toll on share prices. The problem facing companies in the sector now is a lack of pricing power leading to margin pressures both in fixed line and mobile. Ultimately when we look across the space, we come to the conclusion that the companies are selling a commodity (data) and the price of that commodity is set to continue to fall.
When you compare the business model of a Telco to that of a mining company there are actually quite a few similarities. Both have high capital expenditure requirements, whether building mines or building networks and both have limited control over the commodity they sell. Miners see the price of their commodities fluctuate with demand and supply whilst supply is the key consideration for the Telcos. The increased supply of service providers in recent years has put pressure on retail prices at the same time the input costs via the NBN have risen. As a result Telstra has been seen their margins fall. For Telstra, EBITDA margins have fallen from around 42% in 2013 to below 35%.
The trend in Telstra’s margins is likely to continue. Having lost their monopoly on the fixed line side, competition is now starting to ramp on the mobile side with a fourth entrant set to enter the market via TPG Telecom (joining Telstra, Optus and Vodafone). Telstra still has the best network and will be the first to roll out 5G on a national basis but price competition is set to intensify. If you examine the business plan that TPG has, the average cost of a mobile plan is likely to be set in the $15-20 range. This is well below what the current major competitors are working off and will most likely lead to price reductions across the board.
We can look abroad to examine what happens when competition increases. In the US, the biggest drag on the Consumer Price Index over the last year has been wireless telephone services. In fact, mobile prices have been falling consistently since 2012 and the falls have accelerated to over 10% year on year recently.
In addition to retail prices falling, increased competition has driven up the price of spectrum meaning costs are set to erode margins as well. TPG is well set to take market share as the disrupter into the market and the others will have to lower prices to compete.
Outside of being a nuisance and taking on the likes of Telstra, a key part of the reason behind TPG’s move into mobile is the potential of wireless technology speeds overtaking the NBN. Telstra in currently in the process of rolling out its 5G network and the others will follow. Mobile speeds and reliability will continue to improve and this has to be a key consideration in the future of the industry.
The lack of a mobile network is something that investors have to take into account when considering the future of Vocus. The company has put together a national fibre network via piecemeal acquisition that has ended up being significantly more difficult than first anticipated. This has put management on the back foot with many internal problems that are yet to be solved. Ultimately, a tie up with Vodafone in some shape or form should be considered but with management’s credibility having significantly deteriorated from a year ago, it would most likely need a full takeover bid from the other party. This is probably an unlikely scenario given that private equity just walked away after getting a look inside.
As for Telstra, a change in strategy is most likely needed. The company is clearly facing increased competition in both fixed line and mobile and needs a new avenue to offset the decline in earnings. In order to do this, the first step is to retain some capital and that is a key consideration in the recent dividend cut. The question now is what they spend it on. One potential idea has to be content. Through its network it enables content to reach consumers; unfortunately it doesn’t manage to capture much of the value. Their recent struggles with Foxtel and the arrival of Netflix will potentially discourage the company from going down this route; however a streaming relationship with a content provider such as Disney (who recently has announced they are removing their content from Netflix) could be an interesting venture. Looking to secure rights to major global sporting competitions as Optus have done would be another option. The value of content globally is going up as the ability to disperse it to consumer’s increases.
Unfortunately, whilst we can talk about what Telstra should do, we aren’t at this stage sure what they will do. The company appears to be destined to be a provider of other people’s content whilst having its margins squeezed via increased competition. It portrays its vision as becoming a world class technology company but seems to have little idea of how to capture the value it provides.
When the government intervenes in an industry, it’s usually best to step out of the way. Government intervention is quite often correlated with shareholder wealth destruction and the rollout of the NBN has been no exception. At this point, despite the fall in share prices, we still don’t believe it’s a time to be overexposed to the sector. On the other side competition increases, it’s usually a better bet to back the new entrant, the one forcing the margin decline on the rest of the industry. Think about Aldi’s impact on Coles and Woolworths and the market share gains they have made. TPG in this instance has the ability to design a mobile network from scratch without any legacy issues. Its low cost mobile option is potentially a game changer for the industry and management has a strong track record of outperforming investors’ expectations. Of the three major listed players it offers the best risk reward profile at this point, albeit in a challenged industry.
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