Pity David Teoh. Having gone to extraordinary lengths to remain out of the spotlight – as far as we know only one picture of the man has ever been published – the executive chairman of TPG Telecom is now a national talking point.
TPG will spend almost $2bn over the next three years building Australia’s fourth mobile network, a decision that has been met with equal parts awe and fear. Awe because of the sheer audacity of the move; fear because it could provoke an all-out price war that will savage profits.
The market has already given its verdict. TPG’s shares plunged almost 20% when they resumed trading following the announcement. Most view it as an expensive gamble.
Mobile entry the right strategy
TPG has the capability to build and operate the network
Long term view needed
TPG has already disrupted the broadband market and has earned a reputation for long-term thinking; depending whether you are customer or competitor, David Teoh is either Australia’s answer to Jeff Bezos or Keyser Soze.
If TPG has been so successful in broadband, why the move into mobile?
TPG has been successful because asset ownership has allowed it to generate scale. That is, it has bought or built infrastructure and then filled it with customers at low cost and high incremental margin. That combination has provided high returns despite low retail prices.
Consider, for example, that TPG generates the same broadband earnings before interest, tax, depreciation and amortisation (EBITDA) margin as Telstra, while charging about half the price.
The NBN upends that business model by turning a high fixed cost business into a high variable cost one.
As an asset owner, TPG could service customers at low marginal cost. Under NBN, each customer now attracts a fixed and variable charge so marginal costs are higher. TPG can no longer rely on scale to generate excess returns and its margins will shrink from 40% to – we estimate – the low to mid 20s.
The defeat of scale allows competitors to enter the market as they can access the same NBN assets and pricing. TPG's only defence now is its low-cost structure and the ability to bundle various services.
Introducing mobile services allows the business to reduce churn, increase average revenue per user (ARPU) and enter a category that might, one day, challenge broadband altogether.
All this is to say that TPG has gone mobile not because of an ambitious expansion but to defend a business upended by external change. TPG's boldness is driven by necessity, not by ego.
Prepare to lose money
Here is the nub of it: TPG will likely lose money on mobile for several years as it builds scale. The mobile business is capital intensive and will require cash to build, cash to scale and cash to maintain. Competitors will fight for customers and prices will be sharp.
At the end of the struggle, however, if TPG can harness scale, it will have created another revenue stream where low costs and scale will generate superior returns. It is, in fact, replicating a strategy that has already worked.
Can they do it?
Building a mobile business from scratch is a mighty task especially when competitors have been running their networks for decades. Can TPG do it?
The proposal is to build between 2,000 and 2,500 towers. That's fewer than expected but, considering the high proportion of 700 MHz spectrum (which can handle fewer base stations) and no legacy spectrum to build, not unreasonable.
A start-up cost of $600m presumes about $240,000 per tower. Industry reports suggest construction costs between $100,000 to $350,000 depending on the site so the quoted number also sounds fair.
We note, however, that TPG will start with far fewer towers than peers. Telstra operates almost 8,000 towers and even Vodafone claims over 5,000. There is concern that TPG's network won’t be broad enough to encourage usage, and quality problems could impair the brand.
Yet TPG is targeting a population reach of 80% compared to at least 95% for the other networks. In effect, TPG is building only in metro locations where they can utilise existing fibre. This is a smart strategy that explains low capital expenditure, but it relies on being able to access the regional networks of competitors.
The ACCC's upcoming ruling on this very issue will be crucial to deciding how much money TPG will ultimately have to spend and, should the ACCC force Telstra to share its regional network, concerns about network reach and quality should largely be addressed.
TPG will also need access to tower sites – the hardest part of its network jigsaw to complete. In Australia, sites are tightly held by Telstra, which controls about 50% of tower locations while independent business Alticom owns another 25%. Optus and Vodafone, between them, own the remaining 25%.
TPG's fibre already connects to thousands of buildings, and this could provide most of its sites, but it will probably need to lease at least some locations from incumbents.
In TPG's favour is that it has purchased the highest quality spectrum for data use. The 700 MHz band carries long distances and penetrates buildings well. Telstra is the largest owner of 700 MHz bandwidth, which is why it was prohibited from bidding in the latest auction.
TPG now owns the same amount of this crucial spectrum as Optus, which sets it up well to offer high speeds, data loads and geographic spread. Vodafone owns the smallest portion. As we have noted, 700 MHz spectrum can operate with lower tower density.
Importantly, TPG will not have to maintain or build legacy spectrum such as 2G (which Vodafone still maintains) and 3G (which all networks still maintain), allowing capital expenditure to be wholly directed towards the latest, high-capacity technology. Ongoing savings will be realised by not having to integrate various legacy technologies.
A pure 4G network is radically different to 3G. The latter is a voice network with some data capability; 4G is a data network well suited to applications in demand today.
TPG already operates an extensive fibre network that can host both mobile and broadband businesses and has built capacity to service millions of customers. Few businesses are as well prepared to launch a mobile business.
TPG has the strategic imperative and, as we have argued, it has the means. But will it make money from mobile? That's a surprisingly difficult question to answer.
The company itself claims it can break even at the EBITDA level with just 500,000 customers. If we assume an EBITDA margin of 30% (Telstra's currently exceeds 40%), this implies ARPU of just $20 per customer per month. This is a sharp departure from the status quo; Telstra enjoys ARPU of about $60.
EBITDA is a poor measure of profitability, though, because it doesn’t count the fixed price of network construction or spectrum which we amortise over 11 years. Doing that and maintaining margins suggests TPG can break even with 2m customers and APRU of less than $30.
Going from nothing (although TPG has about 400,000 customers as a Vodafone reseller) to 2 million customers may seem like a leap but, as Table 1 shows, it still represents a market share of just over 6%. Vodafone still boasts over 5m customers despite a myriad of problems over recent years.
The mobile market itself continues to grow with population growth and ever more device connections. The adoption of 5G should see a rapid increase in use as more devices are connected.
On a pure net present value calculation, TPG's proposal loses money if we assume no residual value for the network after 11 years. Our guess is that most analysts have made that calculation and it explains widespread negativity about the deal.
TPG’s spectrum will lapse in 11 years but the other parts of the network will remain; towers, sites, fibre, customers and the brand will all have value even as spectrum needs renewal. Sticking a residual value of zero on those assets probably isn’t right but we accept that, at this early stage, valuing the mobile venture is hard.
Much will depend on the reaction of competitors who have fat margins and an $8bn profit pool to protect.
It is likely that incumbents will move aggressively to ward off TPG which may have to wear losses for several years. The free cash flow we envisioned in Opportunity calls at TPG won’t appear and the apparent PER will increase as mobile costs grow.
We think it prudent to include a small negative value for the mobile business as it builds scale; somewhere around -$400m or about 40cps.
That doesn’t mean the venture is a bad idea. Over time, this is the right strategy and the business has been savvy in its execution. TPG is playing a long game and investors need to do the same. This isn’t the time to back up the truck but it is an opportunity to start building a position in a better than average business at a mildly cheap price. BUY.
Note: The Intelligent Investor Growth Portfolio owns shares in TPG and intends to take up its rights. Find out how you can invest directly in this and other Intelligent Investor and InvestSMART portfolios by clicking here.