Tpg kills the amaysim model

TPG has turned the Australian mobile market on its head. We all knew it was building a mobile network and, in The mobile price war is here last month we examined the economics of that network, concluding pricing would be aggressive.

Yet even we gasped when TPG announced the initial pricing of its forthcoming 4G network. TPG will offer six months of 4G access – with unlimited data – for free, after which it will charge $10 a month. Cue the gasp.

This is by far the most aggressive pricing the domestic mobile sector has ever seen.

By contrast, Telstra generates average revenue per user (ARPU) of $65 per month and amaysim’s $10 plan offers just 1 gigabyte (gb) of data per month. The rest of the industry must now respond.

No-one is close to TPG’s proposed pricing and it demands tough action from peers. A tough response is also warranted from investors.

In this review, we make three recommendations. The first is to sell amaysim; the second is to continue to Hold Telstra; and the third is to reiterate our Buy on TPG Telecom – albeit with a call for patience.

Disruptor disrupted

amaysim was the original mobile disruptor. When we first recommended the stock a couple of years ago in Unlocking value in amaysim it generated low margins. But, with a growing subscriber base and a low-cost model, we expected market share to grow and margins to climb.

For a while, that happened. amaysim offered no expensive handset subsidies, low customer acquisition costs and the lowest operating costs in the industry (see Table 1). That translated into low prices, attracting more customers and lower prices.

Between 2015 and 2017, earnings before interest, tax, depreciation and amortisation (EBITDA) margins doubled as subscribers grew and operating leverage worked.

Source: InvestSMART

Competition, however, has intensified. amaysim has lowered prices, but lower ARPUs are tough to absorb with low margins and high fixed costs. As ARPUs tumbled, new business lines were added; amaysim now generates more than half its profit from energy.

As we explained in amaysim: downwardly mobile, mobile price deflation has forced a strategy tweak and the business is now using its low customer acquisition costs and low prices to cross-sell additional products.

It’s a strategy that has worked for resellers overseas and Kogan has shown it can work here. So we were willing to give the idea time but TPG has changed everything.

Sizing up

TPG can match or beat amaysim for operating cost and customer acquisition costs. It can marshal resources from its broadband business and has every incentive to lose money to build scale, breaking amaysim’s strategy and with it our investment case.

As a reseller, amaysim’s competitive options are limited. ARPU, which has already fallen from $27 to less than $20 must now fall towards $10.

With gross margins of about 30%, gross profits could fall to just $36 per subscriber per year. That will savage operating profits and places even more pressure on the energy business, which is also fiercely competitive.

We acknowledge that the business appears cheap. The energy business alone should be able to generate about $25m in EBITDA, so an enterprise value of $270m isn’t dear. And a price war makes a large bank of customers attractive. 

Yet lower profits reduces the value of those customers. With an ARPU of $20, amaysim’s customers are worth at least $1.30 per share; with an ARPU of $10, that number falls to just 70 cents. The subscriber base is no defence against further falls in value.

Lower value is compounded by higher risk. Falling mobile margins leaves less cash to service nearly $80m in net debt and a capital raising from here would be a disaster. We’ve seen amaysim benefit from operating leverage; we might also witness how damaging this can be in reverse.

The market has already slashed the share price in anticipation of pain and, if amaysim’s cross-selling plan works, there's considerable upside. But risks have also risen enough to make this an unattractive bet and we recommend that you SELL.

This recommendation has been a mistake, delivering a 50% loss. Higher margins and customer gains blinded us to more important shifts in the industry. Falling ARPU should have raised more concern and we placed too much emphasis on amaysim's cost advantage (see Table 1). As a reseller, we should also have focused more on the fragility of amaysim's business model.

Among the harder acts of investing is to balance one truth (low costs) against another (more competition). Success demands that we show patience but too much patience can steer into stubbornness. Our hands are up: we've been guilty of the latter.

A lot to lose

Telstra boasts a dominant market share, the strongest margins in the industry and best in class infrastructure. Yet it trades at less than nine times historic earnings. Why is this not a screaming buy?

The answer is that the earnings reflect Telstra’s high margins, but these are a prize to lose.

Between 2010 and 2017, Telstra’s EBITDA rose 70%. Margins and profits expanded as customers flooded onto a network with largely fixed costs. Customer growth from that period reflected higher industry growth and a dismal performance from a single competitor (thank you Vodafone).

We’ve argued before that Telstra’s seemingly stunning mobile-led growth was the result of an uncompetitive market structure. Competition is back.

Vodafone has been recapitalised and is again growing market share, so easy margin gains for Telstra have gone. Like the rest of the industry, ARPU and margins are falling and TPG is likely to hasten that decline. Most investors would agree that Telstra’s $10bn EBITDA will fall. We think it could fall a long way, led by its most profitable category, mobile.

Going backwards, fast

Telstra currently generates 40% EBITDA margins from over 17m accounts to make about $4bn a year in operating profit from its mobile business. Those are big numbers, supported by the best network in the country and the highest-spending customers.

Yet even Telstra can't evade price falls. ARPU has already fallen and we think it has a long way to go. TPG and other competitors could force APRU to fall from $65 today to below $50 and we expect EBITDA margins to crumble from 40% to 30%.

That will have a calamitous impact on profit, which would fall from over $4bn today to less than $3bn. And that is from Telstra’s best business.

The broadband business is also struggling from lower margins as the NBN grows to transform Telstra from an asset-owner to a reseller.

Just two years ago, Telstra was making more than $3bn from its voice and broadband businesses. We think this will fall to just $1bn over the next two years.

The fast-growing network application business is no saviour; it makes just $100m a year and merely offsets falling profits from the data business. Together, these service segments will be a larger part of Telstra in the future but not enough to offset the shrinking parts.

One bright spot for Telstra is that the NBN will pay about $1bn in annuity income for the use of infrastructure. This is government-backed, high-margin income that is valuable. But it's not enough.

Source: InvestSMART

Altogether, $10bn of EBITDA should fall to about $7bn over the next few years (see Table 2). Count depreciation and amortisation and EBIT will fall from $4bn to $3bn. 

Telstra’s coveted dividend won't hold. In fact, it is likely to be cut a long way, perhaps halving from 22 cents per share to 10 or 11 cents. So ignore today's attractive yield – it is a mirage.

This is no bargain and now is not the time to start piling in. Yet lower value needs to be balanced against the strengths of the business and the options available to it.

Smooth operator

Telstra is an outstanding mobile operator with every infrastructure advantage. With the right management and strategy, it could do well, especially from this price. Yet we are concerned about management and capital allocation.

Telstra earns most of its money from broadband and mobile. Its entire competitive advantage – in scale, infrastructure and knowledge – lies in these realms – yet it has delusions of grandeur, apparently wanting to become a global technology business.

Poor capital allocation is a serious risk. Telstra still generates strong free cash flows and will receive billions from NBN payments.

We fear much of that cash will be wasted under current management who have shown an inclination to buy seemingly random businesses and to follow industry buzzwords and fads. Telstra may be cheap but low multiples are well deserved.

We’ve based our price guide on expected EBITDA of about $7bn from 2020 and low multiples to reflect low growth and capital allocation risk.

We would consider upgrading closer to $2.20, which values future EBITDA at six times enterprise value. HOLD.

Buy TPG

The misfit of the sector is surely TPG. It is not solely responsible for the current mayhem but it has certainly played a part by announcing seemingly irrational pricing. It is hard to imagine that TPG will generate profit from its $10 mobile plans.

Yet, as we explained in The mobile price war is here, TPG is playing a long game and is doing things very differently from peers.

Its mobile network will be limited and urban, boasting low costs and high utilisation. TPG is likely to share infrastructure to support broadband and mobile markets and will build scale before building profits.

Investing in TPG will require patience. The price war provides an opportunity to start building a position although we recommend keeping initial allocations low to leave room for additional purchases should prices fall. TPG could get ugly before it gets better but the best purchases are made amid fear and before the consensus turns sunny. BUY.

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