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TPG Telecom – Teoh D’oh!

In what might be declared David Teoh’s first mis-step in the TPG Telecom story, the market snipped $1.9 billion from the value of the company on the back of mediocre earnings growth guidance for the 2017 financial year.
 
As with everything this company does, there’s more to it than meets the eye.
 
NBN margin hole
 
The NBN is proving to be a difficult proposition for retail ISPs like TPG which have been used to higher margins on their broadband services. The NBN is eating into those profit margins and is clearly creating a headwind.
 
Lower margin NBN product is probably the main reason why TPG’s FY17 earnings guidance was substantially below what the market had previously been expecting, hence the sharp reaction in the share price.
 
Singapore Sling
 
TPG announced in September 2016 that it had entered into a process in Singapore that could potentially lead to acquiring mobile spectrum and building that country’s 4th mobile network.
 
The process has some way to go and there is no guarantee TPG will be successful, but if it is, then the company appears to be heading toward a major investment outside Australia that will be funded from existing debt facilities and cash from Australian operations.
 
If the Singapore option is a goer, then investors should be pleased that the rumoured foray into New Zealand’s third ranked mobile network, 2 Degrees, has been iced.
 
Vodafone deal
 
Leaving that aside for the moment, TPG has another major initiative currently underway that is also chewing into the company’s cash flow.
 
In October 2015, TPG announced a $300-400 million deal to add about 4,000km of dark fibre to Vodafone’s network of cell sites across Australia and to migrate its mobile customers (pre the iiNet deal) to Vodafone’s network. TPG will provide dark fibre services for the next 15 years to Vodafone with minimum contracted revenue exceeding $900 million.
 
The relationship with Vodafone keeps growing closer.
 
iiNet acquisition
 
After an intensely fought battle with M2 Group last year, TPG paid $1.56 billion to acquire iiNet which brought in almost a million broadband subscribers and 171,000 mobile customers. There are significant synergies between the two companies that can add value to the group and it gives TPG a substantial 25% market share in retail broadband.
 
TPG has spent a considerable amount of time and money increasing its own fibre capacity across the country as the basis for carrying its own traffic and hence controlling its own costs. TPG acquired PIPE Networks in 2009 for this purpose and has consistently built its own capacity, in particular its fibre-to-the-building program of recent years.
 
The acquisition of iiNet therefore was a step in the other direction of acquiring customers, not capacity.
 
Mobile manoeuvres
 
In February this year, TPG surprised the market a little by bidding for and winning quite a big chunk of 1800 MHz spectrum for $84.7 million, mainly in regional locations across Australia.
 
This spectrum complemented TPG’s 2013 purchase of nationwide 2.5 GHz spectrum and as Mr Teoh put it, “this further investment in spectrum represents the beginning of the next exciting chapter in TPG’s development”.
 
Mobile services has arguably been the weak spot in TPG’s armoury and it has contributed little to group earnings in the past. But the closer relationship with Vodafone and TPG’s own willingness to invest in mobile infrastructure suggest it is no longer prepared to rely solely on fixed line broadband for its future earnings. 
 
Brave and fighting words, but TPG has a mountain to climb in the mobile world.
 
Reality or rout?
 
The savage share price decline following the result release is a salutary reminder of how expectations can so easily evaporate. But is the market thinking with its short term hat on or has it discounted the probability that TPG can generate good earnings growth in the longer term from its much bigger asset base?
 
Telstra gets valued by the market at between 7-8 times its EBITDA as do many other reasonably mature telecommunications carriers. TPG has attracted a premium to that multiple for some time partly based on its very good track record of outperforming expectations as it has grown.
 
Guidance for FY17 capex of $370-420 million is some way above FY16’s $271 million and includes the remaining $72 million payment for the 1800 MHz spectrum, $50 million for international cable capacity and the big fibre rollout for Vodafone.
 
The capex guidance obviously doesn’t include anything for the Singapore option but will need to be accommodated if it becomes a reality.
 
All this growth capex says TPG’s future free cash flow might come under pressure if the operating cash flow doesn’t keep pace. The indications that the NBN is putting pressure on gross margins detracts from that confidence.
 
At the new share price level around $9.50, TPG is now being valued at approximately 11 times FY17e EV/EBITDA and a PE multiple around 20x. Maybe that still sounds a bit expensive relative to Telstra but it still captures some growth expectation in what is undeniably a very competitive industry.
 
Believers in David Teoh’s ability to create shareholder value may simply have to elongate their time horizon to allow all these developments to mature.
 
One thing the company could do better is the way it communicates with the market. With so much going on in FY16, it has barely made a squeak about its progress. For the FY17 guidance to be so far below what the market had been thinking says plenty about the need for greater transparency.

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