TPG Telecom: Interim result 2017

It's still too soon to make it official but TPG's interim result went some way towards validating our investment case (outlined in Opportunity calls at TPG).

Yes, broadband margins are being pinched but the acquisition of iinet, build-out of independent fibre, growth in the corporate business and potential ventures in mobile all go some so way towards offsetting margin decline.

In aggregate, revenue grew 9% while earnings before interest, tax, depreciation and amortisation (EBITDA) grew 28%. Some of this increase was due to expanding margins from bringing iinet customers onto TPG infrastructure, but cost-cutting was also significant. iinet now generates an EBITDA margin of 26%; before being bought by TPG it made just 18%.

By contrast, TPG's consumer business generates an EBITDA margin of 38%. With lower levels of service, we expect that TPG's margin will always outstrip iinet's, but the two should continue to converge.

Corporate jewel

The corporate business continues perform strongly, increasing revenue by 4%, EBITDA by 7% and expanding the EBITDA margin from 40.6% to 41.8%. We've highlighted previously that this is arguably the best bit of TPG and the margin should continue to increase as more customers are placed onto TPG-owned fibre. As a reminder, the corporate business, which accounts for about a third of EBITDA, won't be impacted by the NBN.

The corporate business enjoys high incremental margins because of the low marginal cost of signing customers on to existing fibre services. It has helped that customers are choosing to leave low-margin voice services and signing on to higher-margin fibre services.

TPG's greatest threat comes from NBN. Subscriber numbers are still modest – NBN represents less than 15% of total broadband customers – but that will grow as NBN access increases. ADSL margins of 40% will be replaced by NBN reseller margins that are much lower.

Margin offset

TPG is growing its fibre to the basement business (FTTB) product, a clever idea that bypasses the NBN and earns splendid margins, but that opportunity is limited to about 500,000 households.

To date, FTTB has successfully offset margin decline and TPG reported surprisingly high broadband EBITDA margins of 40%. That will fall as the take-up of NBN accelerates. We expect margins to eventually fall towards the mid-20% range. The FTTB business is exposed to some regulatory risk with regulators threatening to increase charges and limit the range of its NBN competing infrastructure. This would certainly crimp profits from the venture but, in our view, there is little justification for changes. We will be watching regulatory outcomes. 

TPG completed its Singapore spectrum acquisition at a cost of $100m. Building the physical network will cost another $200m–300m, cash that should come from operating cash flow. Returns from Singapore will be small, but money may not be the main motivation.

Singapore is a test tube where the business can learn how to run a mobile business in a competitive market with strong incumbents, while the small coverage area should keep start-up costs low. Ultimately, TPG has designs on running an Australian mobile business.

Mobile future

TPG already owns some spectrum and will likely be a bidder for upcoming spectrum that the regulator has ruled cannot be bought by Telstra. Its fibre network could be used to support a mobile business as well, but it will still need to spend up to $2bn building a physical network.

That hasn't yet been confirmed by the company but it is, in our view, the most likely outcome and will come attached to new risk.

Capital expenditure will remain high. In the short term, constructing fibre for the Vodafone contract is now incurring costs without generating revenue; Singapore expenditure will soon follow and, if TPG fulfils its mobile ambitions, capital expenditure could rise again. Capital expenditure for this business has a high discretionary component but that might not matter if TPG goes all out chasing growth. 

High reinvestment rates combined with uncertain rates of returns mean this recommendation relies to a degree on our faith in management. A splendid track record helps in that regard and, with an enterprise value to EBITDA multiple of less than 9, TPG is attractive enough to start building a position. BUY.

Note: The Intelligent Investor Growth Portfolio owns shares in TPG. Find out how you can invest directly in this and other Intelligent Investor and InvestSMART portfolios by clicking here.