TPG Telecom: Interim result 2019

The NBN is disrupting the telco industry. The migration of millions of broadband customers from legacy copper wire onto (mostly) fibre owned by the NBN is one of the biggest upheavals ever faced by the industry.

It means that every provider of broadband has become a reseller of wholesale fibre. Wholesale prices have risen from roughly $15 to around $50 per user per month. Unsurprisingly, margins have been crushed across the board.

Telstra complains it is making no money and even the leanest competitor in the market, TPG, is facing lower margins. That was clear in TPG's interim result, which paints a poor picture of its consumer business.

A combination of lower gross profit, declining margins and lower customer growth combined to cut almost $30m from earnings before interest, tax, depreciation and amortisation (EBITDA) in the consumer segment. 

Worse still, wholesale discounts offered by the NBN over the period will soon roll off and margins will fall further. 

With so much bad news from the NBN migration, you might expect the overall result to be lousy. It wasn't. 

Go corporate

Total EBITDA actually rose modestly to $424m for the period. With the NBN capturing all the attention, many forget that the best part of TPG is actually its corporate business and it remains in fine fettle.

While consumer EBITDA fell 5%, with margins of 29%, the corporate division grew EBITDA 15% and generated margins of 48%. As expected, the corporate business is increasing margins as revenue expands. It now accounts for 43% of group earnings.

TPG is finally generating cash from a large fibre contract with Vodafone and that single deal explains much of the growth in this half. Margins from that project are likely to be around 80%. 

Corporate earnings were also helped by moving customers onto fibre products which scale beautifully. Ultimately, margins from the corporate business should approach 60% as utilisation of fibre assets grows and low margin voice revenues decline.

Counting and accounting

For a business already renowned for low costs, TPG managed to eke out further savings, lowering costs in the consumer segment by 9%. This went some way towards offsetting lower average revenue per user (ARPU) and high wholesale costs. Management also suggests there are further savings to come. 

This was also the period TPG recognised losses from abandoning its mobile network. The carrying value of mobile and spectrum assets was written down by $227m and this showed up on the income statement. It's why statutory profits appeared so low and headlines were able to scream of lower profits.

While the statutory numbers show a genuine loss of value, they don't represent the cash the business can generate. 

Investors should prepare for more accounting shocks to come. The full-year numbers will include amortisation of spectrum costs and, since the mobile network is no longer commercial, TPG will also start to recognise a large chunk of its interest payments as a direct cost instead of capitalising them. Reported numbers could look rather weak but the underlying business should generate between $800m-820m in EBITDA for the full year.

One positive from abandoning the mobile project is that capital expenditures should fall dramatically to about $200m a year. Free cash flow, then, should be strong and ought to go towards reducing net debt, which stands a $1.6bn. 

Endgame

Broadband has built the business and fibre has augmented it, but mobile will define the future for TPG. The merger with Vodafone remains crucial and its outcome unclear. 

A rational regulator should recognise that a merged Vodafone and TPG would provide stronger competition for Telstra, which remains bafflingly popular across mobile and broadband, charging premium prices and collecting above average margins (in mobile, anyway). 

Yet the ACCC remains firm in its conclusion that the merger may prevent the introduction of a fourth competitor, a harder argument to make now that TPG has abandoned its mobile network. 

We think the odds are in favour of the merger proceeding but there's still a possibility it won't.

If TPG is denied access to Vodafone, it will be seriously injured. A merged entity could combine TPG cost and marketing nous with Vodafone's physical infrastructure to attract new customers onto an underultised network and collect higher margins. 

In particular, the merged group could use TPG's corporate distribution channel to sell mobile products and challenge Tesltra's supremacy in corporate mobile. 

It's possible to imagine TPG being worth about $10 a share if the merger proceeds. Without it, however, TPG must return to the drawing board and conceive a new strategy. 

With a wide range of possible outcomes, we're comfortable with our current Buy price of $6 but less conservative investors might choose a higher entry price. Good businesses find a way of overcoming obstacles and, as these results show, TPG remains a good business. HOLD.