CFA Institute Research Challenge Hosted by CFA Society Sydney Abercrombie & Co The CFA Institute Research Challenge is a global competition that tests the equity research and valuation, investment report writing, and presentation skills of university students. The following report was submitted by a team of university students as part of this annual educational initiative and should not be considered a professional report. Disclosures: Ownership and material conflicts of interest The author(s), or a member of their household, of this report holds a financial interest in the securities of this company. The author(s), or a member of their household, of this report knows of the existence of any conflicts of interest that might bias the content or publication of this report. The conflict of interest is that one of the authors, or a member of their household, of this report holds stock in the company. 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This report should not be considered to be a recommendation by any individual affiliated with CFA Society Sydney, CFA Institute, or the CFA Institute Research Challenge with regard to this company’s stock. Abercrombie & Company Abercrombie Has the Golden Child Telecommunications Operators & Company Lost Its Shine? Australia | Australian Securities Exchange (ASX) Company: Telstra (“TLS”) Date: 19-Sep-2018 Closing Price: AU$3.21 Sell (-20.2% Total Return) Ticker: TLS-ASX Target Price: $2.67 Executive Summary TLS-AU Overview We initiate coverage on Telstra (TLS-ASX) with a SELL recommendation based on a 12-month price Target Price [A$] 2.67 target of $2.67, representing a -20.2% downside from the last close of $3.21 on 18 September 2018. Telstra’s (TLS-ASX) substantial competitive moat as the nation’s wholesaler has been eroded via the Last Closing [A$] 3.21 18/09/18 introduction of the National Broadband Network (NBN). The reduction in barriers to resell broadband opened the competitive landscape for nimbler players to enter and grow market share. TLS is hanging Market Cap [A$m] 38,140 its hat on its ability to generate long-term value from the 5G rollout and recoup losses incurred due to Shares Out m 11,878.9 fierce competition in the mobile and NBN space. But this bet is not likely to yield sizeable returns amidst a hypercompetitive environment. Without this growth potential, other strategies like Telstra2022 cost cuts 52 Wk High [A$] 3.79 to improve margins will not sufficiently compensate for low mobile and NBN returns to drive up EPS. 52 Wk Low [A$] 2.60 1. Rising Mobile Competition | Prepare for the Game of Phones Table 1: Price History (Rebased) With 44% of TLS’s revenue derived from its mobile segment and the less attractive economic profile of ASX200 - Rebased TLS NBN, increased reliance is placed on their ability to capture market share in the mobile space. i) Tightening Competitive Landscape: The market believes the proposed merger of TPG (TPM) $8 and Vodafone (VHA) will lessen competition and concentrate the industry. Our analysis suggests that the merged entity will have the bundling benefits and intent to be a stronger challenger to TLS and will be able to compete for more than their 20% mobile market share. $6 The resulting competitive pricing in the mobile space could erode Average Revenue Per User (ARPU) and increase subscriber churn for the incumbent, triggering an earnings downgrade. $4 ii) Customer Flight: Reduced customer satisfaction from recent network outages has left TLS near all-time low Net Promoter Scores (NPS). This lays the foundation for customer flight in the run up to the NBN’s churn event, which could see TLS struggle to retain mobile market share. $2 2. All in on 5G | Hold the Door for Rivals to Enter 5G 2013 2014 2015 2016 2017 2018 Source: Abercrombie & Co Analysis Historically, the rollout of new mobile networks (e.g. 3G and 4G) marked TLS’s opportunity to boost mobile margins by commanding increased ARPUs as the first-mover of the superior network. This Graph 2: Returns Analysis expectation will not be met for the upcoming 5G rollout in a hyper competitive market as the telcos, Optus 8% and a potential TPM-VHA, will be as ready as TLS for 5G. WACC: 6.6% iii) Optus and TPM ready to go: TLS’s historically high mobile ARPU will subdue to 1% growth at 6% the commercial launch of 5G. Optus is committed to launch alongside TLS with sufficient spectrum and 5G trials, and the TPM-VHA merger could guarantee maximum spectrum since 4% without the merger, the individual entities were limited by their debt capacities. iv) Differentiation is King: The upcoming 5G release and NBN migration underscores a major 2% churn event. We believe TLS will lose 4% market share, as they struggle against Optus’ product differentiation (content-driven strategy) and TPM-VHA’s cost differentiation (product bundling). 0% 16 17 18 19 20 21 22 23 3. Commoditised NBN | Winter is Still Coming ROIC ROE The NBN rollout has triggered the migration of TLS copper customers to the new network. However, we Source: Abercrombie & Co Analysis expect more earnings pressure as competitors improve the quality of connections. Combating these rivals may compromise cost cuts that TLS relies upon to stave off a significant dividend reduction. TLS-AU Key Financial Data FY18 i) Incumbent’s Curse: Despite competition pushing down ARPU, TLS has always at least D/E 46.8% maintained their network quality advantage. New changes to the Connectivity Virtual Circuit (CVC) cost that telcos must pay to support bandwidth speeds will finally catalyse unprecedented Net Debt/Equity 1.6x quality convergence between competitors. The $2.5bn cost savings program is also unlikely to Dividend Yield 7.1% yield EBITDA relief amidst an unreliable record and accelerating cost of sales. ii) Indebted to the Dividend: TLS has always been viewed as a high dividend yield firm for an 1 EV/EBITDA 5.4x enormous retail investor base. But earnings headwinds from NBN, mobile and capex needs P/E(LTM) 10.6x mean a major dividend cut is imminent to retain an A credit rating. (1) EV/EBITDA (exc. NBN one-offs 6.3x) Financial Analysis FY18A FY19E FY20 2021 2022 2023 CAGR Revenue [A$m] 26,904.0 25,462.3 25,237.1 25,457.3 26,242.2 27,217.9 0.2% EBITDA [A$m] 9,656.0 9,372.1 9,264.0 9,319.4 9,580.5 9,909.5 0.4% EBITDA Margin [%] 0.4 36.8% 36.7% 36.6% 36.5% 36.4% 0.2% EBITDA Growth [%] (6.8)% (2.9)% (1.2)% 0.6% 2.8% 3.4% NPAT [A$m] 3,008.0 2,548.7 2,427.6 2,394.2 2,278.6 2,392.2 -3.7% NPAT Growth [%] (5.5)% (15.3)% (4.8)% (1.4)% (4.8)% 5.0% Postpaid Mobile ARPU [A$m] 58.05 55.73 54.62 53.53 53.53 53.53 -1.3% Postpaid Mobile ARPU [%] (4.4)% (4.0)% (2.0)% (2.0)% - - Growth 1 Diagram 1: Revenue Business Description Breakdown in FY18 Other (inc. General Overview Media) 6% Having transformed from its former status as a government owned natural monopoly, TLS is one of Global Connectivity Australia’s darling telecommunications companies. With dominant market positions in mobile and fixed- 6% line spaces, TLS boasts a 16.7m mobile customer base and provides access to 11m fixed-line services. These two segments collectively comprise 62% of TLS’s total revenue (TR) (See: Diagram 1). It has NAS recently come under a change in focus and structure in both areas. From 2014, it began disconnecting 14% fixed customers and moving them onto NBN representing a move from a wholesaler of broadband to a Mobile retailer. TLS also has footholds in more peripheral telco services. Whilst Data & IP (10% of TR), NAS 40% (14% of TR) and Global Connectivity (6% of TR) have promising, albeit historically volatile, growth, they represent a small proportion of TLS’s TR. Despite the proliferation of its products in Australian homes Data & Fixed IP (Exc. One- and enterprises, TLS’s historical performance over the last five years reflects that of a company forced 10% offs) to adapt rather than one undergoing a smooth transition. EBITDA margins have declined from 42.4% to Recurring 22% 35.9% between FY13 and FY18. The declining EBITDA figures are a result of (1) TR growth of 1.91% NBN DA over the same period on a CAGR basis, and (2) Increasing operating costs of 5% p.a (See: Diagram 3). 2% Source: Abercrombie & Co Analysis Business Model TLS’s business model follows a matrix configuration; six broad products that run laterally across three Diagram 2: Mobile Revenue Breakdown in FY18 ($m) end consumer groups: Personal, Small Business, and Enterprise (See: Diagrams 2 and 4).