Telstra: is it safe yet?
TPG's proposed merger with Vodafone makes it a more powerful threat to the status quo.
TPG's proposed merger with Vodafone is being interpreted as an unambiguously good thing for the industry in general and for Telstra specifically. The rally in telco stocks as the deal was announced was the closest thing you will see to the market breathing a collective sigh of relief.
TPG, the rogue startup that has stunningly captured a quarter of the broadband market, had threatened to unleash a brutal price war to fill a proposed new mobile network with customers.
If the merger with Vodafone goes ahead (and we think it will) then surely such hyper aggression will moderate and the status quo, that is, Telstra generating great returns while Optus and Vodafone do enough to get by, would resume.
There is some logic to that conclusion. It's unlikely that Australia, with a large landmass and low population density, can ever support four networks. Previous attempts to break the oligopoly ended up bust or taken over. America, with a similar land mass and much higher population density, hasn't even been able to support a credible third network.
The merger, then, would be a pacifier for TPG, neutering its aggression and restoring the status quo to the industry.
That is the wrong conclusion to make. TPG hasn't been pacified or neutered. It's now stronger than ever.
Far from restoring the status quo, the merger will ensure its upheaval, handing the dogged TPG an upgraded and improved Vodafone mobile network.
TPG succeeded in broadband because it married industry leading operating costs with a suite of scalable infrastructure assets.
The TPG formula is to own networks, fill them with customers and let scale grow margins. Low cost and low prices allow TPG to find customers cheaply and a scalable asset base means margins rise as customers grow.
This has been spectacularly successful. TPG has generated the same EBITDA margin as Telstra even though it charges half the retail price. The NBN has broken this formula in broadband, forcing TPG to accept reseller margins, but the marriage of low costs and scalable assets is again at work with the Vodafone merger.
Vodafone's large and much improved network is underutilised and under earning, generating margins of just 27% against Telstra's industry leading margins of over 40%.
Vodafone's low returns are partly because of higher costs - for example, it spends $300m a year to run retail stores and attract customers to its network - and partly because it doesn't have enough customers to scale the network.
TPG will do what they have done in their own business and in every acquisition they have made. They will cut operating costs using their own cost model and then slash prices to attract more customers onto the network. Economics will do the rest and margins should rise.
They won't get to Telstra's 40% but they are likely to pass 30%. More customers at higher margins will mean better returns from an asset base that, at the moment, is making subpar returns.
There is also a new opportunity to use TPG's enterprise distribution to sell mobile products and to share fibre and spectrum assets. The merger allows TPG to be more, not less, aggressive. And if it follows the strategy it has in the past, it will earn splendid returns while cutting prices.
Telstra is a fine business and among the best mobile operators in the world. Yet it is notoriously high cost, bureaucratic and slow to adapt. Over the past five years, revenues have grown 3% and operating costs by 25%. Planned cost cuts will hardly dent decades of ingrained cost increases.
There will be no respite from a TPG/Vodafone merger. Anyone who thinks that, after decades of aggression and an obsession with low cost, TPG will simply accept the status quo doesn't understand that business.
TPG is now a more powerful and credible threat than ever. Telstra shareholders shouldn't be complacent. They should be scared.
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