Telstra v. Singtel: Why Singtel wins

Singtel and Telstra have much in common, but are deriving profits from different regions – and face different challenges when it comes to capturing Asia.

Summary: Telstra and SingTel are two of the largest telco companies in the Asia Pacific, and the two face different challenges and opportunities for growth. SingTel faces new entrants into the Singapore and Philippines markets, but has steady core earnings and exposure to emerging Asian markets. Telstra’s Australian mobile business is going strong, but it faces challenges as demand for its fixed line business looks to slow in coming years. Analysts believe Telstra is trading at above intrinsic value.

Key take out: SingTel has a strong core domestic business and also has significant exposure to emerging Asia, and analysts see it as trading around fair value. Telstra’s Australian mobile business is performing well and is working on an 'Asian strategy', but faces a structural decline in its fixed business going forward.

Key beneficiaries: General investors. Category: Shares.

Bernstein rates Singtel Market-perform with a target price of SGD 3.90. 

It rates Telstra Underperform with a target price of AUD 4.70

* The report here is from Barron's, these stocks do not constitute formal recommendations from Eureka Report. To see Clay Carter's recent assessment of Eureka Report's formal recommendations on US and international stocks, click here.

Singtel and Telstra are the two primarily developed-market Telcos in our coverage. Both have much in common: they are two of the largest telecommunication companies in the Asia Pacific, operating in English-speaking countries and listed on easily accessible stock exchanges. Both are incumbents in their home country; have high quality management and good corporate governance; both are good dividend payers with a high payout ratio. However, whereas Singtel derives ~50 per cent of its profits before tax (PBT) from regional (emerging Asia), Telstra is still mostly Australian with only ~2 per cent of total earnings before interest, tax, depreciation and amortisation (EBITDA) coming from international operations. 

Last year we published a comparison between Singtel and Telstra and argued that the risk return balance had shifted from Telstra to Singtel. We followed that up with a downgrade of Telstra several months later. 

Today we once again assess the outlook for the two stocks in light of new information, recent trading and updated strategies as articulated by the companies.

Since our last call last year, Singtel has experienced a number of new developments:

- On the negative side, Singtel faces new potential entrants in Singapore and the Philippines. iDA, the Singaporean regulator, has proposed to reserve spectrum for a new entrant in Singapore. While we expect any new entrant will impact Singtel the least (of the three local operators), it will still have a negative impact on Singtel’s Singapore business. We expect this would reduce Singtel’s value by S$0.17 per share. The Telstra/San Miguel entry into the Philippines (if it goes ahead) will similarly impact Globe and its returns – reducing Globe’s DCF valuation by as much as ~40 per cent. However the impact on Singtel will be just S$0.06 or ~2 per cent. Any earning impact will not be visible for a few years as the new entrant will need to ramp up network deployment and start acquiring customers. AIS is facing earnings pressure (and will possibly be forced to cut their dividend payout ratio) due to extremely expensive spectrum auctions (the second auction is scheduled for Dec 15th). We expect their earnings to fall by ~36 per cent over the next three years. Lastly, while not new news, the impending launch of Reliance Jio in India has put pressure on Bharti Airtel’s share price as the market worries about the impact Jio will have on high value customers and/or pricing levels. Moreover continuing currency headwinds in Africa weigh on Bharti’s reported profitability.

- On the positive side, Optus is gaining relative momentum in a slowing market and Telkomsel continues to outperform. Since Optus shifted strategy from defensive cost-cutting to aggressive revenue growth, they have accelerated postpaid subscriber net adds and mobile service revenue growth. While they are yet to catch up with Telstra, the gap is narrowing. However, we expect intensifying competition will drive down average revenue per user (ARPU) and revenue growth and believe Optus’ plateauing growth last quarter is a precursor to this slowdown. Telkomsel however continues to go from strength to strength and has reaccelerated growth in both revenues and earnings.

- When we add up the components and update the exchange rates, we conclude the current share price of Singtel is fair compared to its intrinsic value. We value Singtel at S$3.82 by summing the DCF valuation of each part, and layering on a discount on international associates for lack of control. This is on par with current market price. Without the holding discount we would value Singtel S$4.09 per share, or 6 per cent above current market price. However, if you believe the fourth entrant in Singapore and third entrant into the Philippines are likely, then the undiscounted value would fall to S$3.86. Applying the lack of control discount to this decreases the value to S$3.60. 

There have also been a few key changes for Telstra

Telstra has further developed their ‘Asia strategy’. However, overall we continue to see significantly more downside pressure than upside: 

- Intensifying mobile competition will slow its most important growth driver. To date, mobile service revenue has continued to race ahead due to 4G usage growth and excess charges. However, we believe growth is plateauing after successive rate cuts and changes to the excess data charge regime. Management mentioned that Q1 ARPU was down slightly and three operators have recently commented on the heightened level of competition. We forecast mobile growth to slow to 3.8 per cent in FY16 and 2.5 per cent in FY17. 

- The accelerated rollout of NBN will ultimately cut returns from the fixed-line business. Under the new multi-technology model, NBN Co has increased the pace of its rollout, aiming to connect almost all premises by 2018. The net impact for Telstra is that cash compensation received for disconnecting customers will also shift forward (a positive for earnings and cash flow), but will also result in an accelerated migrating to a resale model which has fundamentally lower EBITDA margins (a negative for long-term value). Long-term EBITDA generation from the Australian fixed-line business will drop from A$5.1 billion in FY15 to an estimated A$2.6b by 2020 and A$1.9b by 2025.

- To close the gap on the eventual earnings decline, Telstra has been investing into two new growth areas. The first is to develop ehealth as an ‘adjacent’ opportunity to their existing telco business. Health was officially organised into a separate division last year to give it the prominence required to warrant senior executive focus. Over the past two years, Telstra has acquired over 16 small eHealth focused firms and entered into a JV with Medgate (a provider of tele-medicine from Switzerland). Revenue in FY2015 is reported to be roughly A$78 million but management has indicated that the division is profitable. 

- The second is to find new growth options in Asia. On this front Telstra has acquired PacNet to improve their pan-Asian connectivity; formed a JV with PT Telkom to target an expected growing need for managed services in Indonesia; and is in discussions with San Miguel Group regarding the launch of a third mobile operator in the Philippines. At the strategy day Telstra executives mentioned they could spend up to US$1b for a 40 per cent share in the venture. SIM based penetration in the Philippines is ~115 per cent - similar to the state of the market when Hutchinson ‘3’ entered Australia. On the positive side, the Philippines is currently a 2-player market (which makes the job for the new entrant a bit easier) and Telstra’s partner reportedly has ~90MHz of spectrum in the 700MHz band. This is a significant amount in a very attractive spectrum band, which will make the job of covering the country significantly easier. While we are generally sceptical on the opportunity to be a new entrant in an existing highly penetrated market, this opportunity looks about as good as it gets. 

- We look to Two-degrees’ entry into New Zealand as an example of a third player entrant into an existing 2-player market. They managed to capture a higher share (and faster) than Hutchison ‘3’ did in the various 3 and 4-player markets they entered. If we give Telstra the ‘benefit of the doubt’ and assume they will follow a share gain trajectory similar to Two-Degrees then we could expect EBITDA break-even by the third year after launch (or year six after starting network deployment; see Exhibit 28); in contrast Hutchison generally only achieved positive EBITDA six years after launch. Even so, we expect the new venture will contribute net profit loss for Telstra for the next nine years. While we have not put any forecast for this into our current Telstra model, this is one more reason why we don’t expect dividend to increase in the near-term. 

- We continue to believe Telstra’s share price is trading significantly above intrinsic value. Our DCF valuation without the investment in the Philippines is A$4.65/share, comparing to the ~A$5.35 level it currently trades at. Moreover we expect the Philippines venture to reduce its DCF valuation by A$0.10 per share. Even in a more bullish case we fail to see how the venture can create value. However, we believe its stock price (in local currency) will likely remain resilient given its current high yield and policy of paying fully franked dividends. 

Singtel shares are currently trading on a more neutral basis, whereas Telstra continues to trade near the top of recent norms. Adjusting for interest in associates, Singtel is trading at 7.4 times EV/EBITDA. This is significantly below that of its emerging market associates (which contribute ~40 per cent of its earnings), and similar to Telstra (trading at 7.5 times) despite the fact Telstra do not have any significant emerging market exposure yet. Given its significant headwinds, we believe Telstra should trade at a significant discount to Singtel on an enterprise value (EV)/EBITDA basis. Singtel’s current dividend yield at 4.5 per cent is also slightly below Telstra at 5.7 per cent, but while the former is reinvesting ~25 per cent of recurring earnings Telstra is only reinvesting ~10 per cent. Lastly, with the continued divergent currency outlook, Telstra’s dividend yield is less secure for international investors than that of Singtel.

What about the franking credits?

Domestic Australian retail investors love their franking credits as they provide a significant after-tax boost to the declared dividend and give support to investments in local companies. For retail investors in Singapore (where investment income is not taxed) there is no impact. For an Australian retail investor, Telstra’s 5.7 per cent dividend yield would be equivalent to a 8.1 per cent yield earned from an unfranked stock like Singtel (Exhibit 31). For international institutional investors there is no difference, but local retail investors make up ~40 per cent of Telstra’s share base and provide significant support for the stock. 

While Singtel and Telstra may appear similar to international investors, the risk-reward profiles are very different. We continue to expect Singtel will generate greater returns over the next few years. Singtel has a stable core business, existing portfolio of dominant emerging Asia operators and limited currency headwinds. In contrast Telstra has a deteriorating core, and is just starting to invest in emerging Asia. Singtel trades at an (adjusted) EV/EBITDA of 7.4 times, similar to that of Telstra. For offshore investors our advice remains unchanged. Australian domestic investors will continue to factor in the benefit of the franking credits but even here we are doubtful they are fully appreciating the risk of a falling share price on overall returns.

Investment Conclusion

In a period of volatility SingTel provides a ‘safe harbour’ for investors while still maintaining exposure to Emerging Asia. Steady core earnings in a strong domestic currency provide security of returns while its diversified associate portfolio provides exposure to a number of major regional Telcos. It is currently trading around fair value, and we rate it Market-perform with a target price of S$3.90. 

Telstra has a fantastic mobile business in Australia, but on-going growth will be challenging. Its fixed business is facing structural decline; NBN payments will top-up cashflows for a few years but the end-game is a much less valuable company. Management has committed itself to acquire a significant presence in Emerging Asia, which we believe will dilute existing shareholders’ equity without generating incremental value.


* The report here is from Barron's, these stocks do not constitute formal recommendations from Eureka Report. To see Clay Carter's recent assessment of Eureka Report's formal recommendations on US and international stocks, click here.

*This report is republished with permission from Barron's.