Value in telco shares

Rapid industry change, especially with the NBN rollout, and increasing competition make it hard for investors to find value

The telecommunications sector endured an annus horribilis in 2016, with slumping share prices reflecting the uncertainty of the viability of various business models ahead of the completion of the NBN rollout. Downgrades, writedowns and capital raisings are just some of the events shareholders have had to endure.

So how should investors think about a complex and extremely dynamic sector and what are some of the considerations before deciding whether valuations have become attractive since the sell-off?

Fifteen years ago life was simpler: a residence enjoyed dial-up internet access, with speeds 100 times slower than today, shopping catalogues clogged mailboxes, CDs and DVDs clogged shelves and drawers, and teens argued about who could use the phone next. Smartphones didn’t exist and the only wireless devices were the TV and roller door remote controls. Back then it took less time to walk to the video store, come home with a DVD, watch the movie and return it than it did to download one.

The speed of change is now as fast as the connectivity we demand from our internet service provider and competition is ensuring prices keep falling. Meanwhile, ever faster speeds create new service categories to which device manufacturers and service providers must enable access.

This recipe of promising more data and services at ever-lower prices is not an easy menu item for operators to deliver. Combined with more than 110 companies offering access to the NBN alone, it makes navigating the future very difficult for investors and therefore valuing opportunities almost 100% guesswork.

Despite declining prices, Australian telecommunications consumers have still had to pay substantial premiums, particularly to Telstra, compared with their overseas counterparts, as well as accepting slower and inferior services. Telstra has benefited most from consumers’ unwitting willingness to pay premium prices. Limited competition, such as where Telstra is the only provider (to 46% of fixed-line services, for example), means some 3.5 million consumers are adversely affected by the market structure.

Meanwhile, it is argued the subsidisation of Telstra, through the universal service obligation (the requirement to ensure that phone services, payphones and prescribed carriage services are reasonably accessible to all people in Australia on an equitable basis) entrenches its market dominance. It might be just one reason consumers are paying more. Other reasons include the disparity in spectrum ownership between operators, which acts as a barrier to competition.

Regardless, data demand is surging. Demand on fixed networks grew by 40% from 960,000 terabytes (TB) to 1.3 mil-

lion terabytes, and mobile data increased by more than 50%, from 72,000TB to 110,000TB. A significant contributor to this rising appetite for data is the preponderance of audio-visual streaming services such as Netflix, Presto and Stan, while a rising number of connected devices in homes – from an average of eight in 2016 to more than 20 in the next four years – will contribute further to data demands.

As an aside, price is also driving data demand. In just the past four years prices for similar data plans have fallen by more than 80%.

This growth in data demand has increased competition between providers of both fixed-line and mobile services, resulting in increased data quotas and bundled subscriptions to streaming services. And to top it off, the telecommunications industry will change significantly as the NBN rolls out. The rollout and migration to the network will raise issues for regulators, the industry and consumers. New bottlenecks may be discovered, there’ll be new pressures on battery back-up arrangements, Telstra may gain a competitive advantage from access to significant information flows, while smaller service providers will demand and require a competitive and efficient aggregation and backhaul market.

To compete against Telstra’s circa 60% market share (and 51% of wholesale NBN connections compared with 24% for TPG and 8% for Vocus), either significant scale or dominance of a growing niche (for example, VOIP) is required. The result has been a wave of land-grabbing mergers and acquisitions, such as Vocus/NextGen/M2 and TPG/PIPE/AAPT/iiNet.

In 2016, total telecoms services revenue exceeded $40 billion and grew at 2% for the 12 months to June 2016. Much stronger than aggregate growth is being generated by second-tier providers; however, Telstra still dominates.

Advances in the digital economy, as well as multi-industry use of the infrastructure and the “internet of things”, will see an ongoing increase in wholesale revenues and open up opportunities in data analytics, cloud computing and services that haven’t been imagined yet, while the connection of literally billions of devices puts pressure on the infrastructure.

As the future moves towards the NBN, it is believed a more level playing field will be created, but margins will continue to be pressured. If you’re thinking the telco sector in Australia is an incondite gallimaufry, you’re not too far from reality.