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Global Telecommunications, Value or Value Trap?

Antipodes Partners’ quantitative tools have progressively highlighted the growing valuation gap between the Telecommunication Sector and the global market. As evidenced in Figure 1, the global Telecommunication Sector has de-rated relative to historical multiples across all regions, ranking close to 1.5 standard deviations “cheap”. Of course, the stocks may be “cheap” for a reason – only fundamental analysis can answer that question, hence, Antipodes Partners has devoted considerable analytical resource to understanding the opportunities across the globe.

CHART 1: MOBILE ARPU RELATIVE TO GDP PER CAPITA VERSUS GDP PER CAPITA (USD)

Chart 1_Mobile ARPU relative to GDP per capita versus GDP per capita (USD)1

Source: OECD December 2016 “Broadband Statistics” report, Strategy Analytics 2016 report, IMF Database, Antipodes Partners

We see the major reason for the pervasive derating is the view that the sector will remain a proverbial black hole for capital spending (or “capex”) and that profitability will continue to decline. After significant rounds of spending on 3G, 4G, and fixed line fibre, investors are justifiably weary of the constant drain on cash flow. Further, some of the major global telecommunication markets remain structurally challenged in other ways:

  • Policy risk exists in many countries, for example we have seen Australia and Singapore suffer heightened competition with the emergence of government owned National Broadband Networks (NBN), reducing existing telecommunications companies to nothing more than resellers.
  • S. mobile ARPU’s (Average Revenue Per User) are high in both an absolute and relative to GDP sense. Further, the intensity of industrywide competition is set to increase as the cable broadband operators attack this large mobile profit pool which will force the mobile incumbents to fight back with greater fibre broadband investment to address their relatively weak offerings.
  • European regulators have generally been reluctant to allow cross-market consolidation and, hence, whilst mobile pricing has stabilised, the competitive environment remains fragile. We own Telecom Italia, which is the fastest mover in providing fibre broadband, and is a cheap exposure to a relatively unique growth in broadband adoption due to very low market penetration (Chart 2).

CORRELATION CLUSTER

Whilst we could not agree more with the history of capex excesses, selectively the future should be very different for incumbent telecommunication companies that have a combination of dense 4G cell site coverage, high broadband penetration (and high proportion of fibre based broadband, Chart 2), and no obvious new broadband competitors. Moreover, these telecommunication companies will tend to have low historic returns on capital employed (“RoCE”) due to having front loaded their mobile and broadband fibre investment and, hence, on a backward looking assessment of profitability, may not initially appear that appealing.

As a result we have settled on Korea (and China) as markets of interest. Our core holding (also top ten) is the Korean ex-government operator, currently the leading fixed line player and second ranked mobile player, KT Corporation (“KT”). In total across different stocks and regions, we have approximately 7% of our Global portfolios and 9% of our Asia portfolio invested in this cluster of opportunity.

CHART 2: HOUSEHOLD BROADBAND PENTRATION AND FIBRE AS A PERCENTAGE OF TOTAL BROADBAND

Chart 2_Household broadband penetration and fibre as a percentage of total broadband1

Source: OECD December 2016 “Broadband Statistics”, Note: OECD excludes Fibre to the Node under the definition of “Fibre Broadband”, Antipodes Partners

IRRATIONAL EXTRAPOLATION

KT’s fixed line broadband internet can serve every apartment building in South Korea, a country of 50m people, with one gigabyte per second internet speeds. That speed is ten times faster than the fastest service available on the Australian NBN and forty times faster than what most NBN customers receive. Whilst the capital expenditure to provide this service hasn’t yet yielded fantastic economic returns, the hard work is done and the infrastructure can be gradually harvested over the next decade or more. In an Australian context, the market’s extrapolation is similar to assuming NBN Co capital expenditure would not fall after the NBN rollout is complete!

With KT’s 5G trials beginning in 2018, the market remains concerned regarding the investment merit of a large scale rollout. A key technical difference to 4G is that 5G will be rolled out on higher frequency spectrum. Whilst higher frequency spectrum offers significant advantages on speed and capacity, its chief drawback is the shorter distance over which a signal may be carried (propagated). Therefore, with each successive generation, physical network density has had to increase, driving higher capital expenditures. However, as confirmed by several large operators, increases in computing power are allowing “Massive MIMO” technology to dramatically lower incremental densification requirements. This technology enables transmission of almost an unlimited number of signals over one radio channel by increasing the number of antennae used, resulting in large increases in capacity and coverage for a given amount of bandwidth. This means densification requirements for 5G are somewhat offset and Korea, as one of the most densified 4G mobile networks globally, should not see any material change in 5G capital expenditure from 4G spend, as some currently fear.

In summary, in Korea (and China), and for KT in particular, heavy densification of the mobile cell site network and near completion of the fiber based fixed line network suggests that we should be entering a period where capital expenditures trend structurally lower than annual depreciation, and that growth in free cash flow accelerates.

MULTIPLE WAYS OF WINNING

Product Cycle
Whilst lower fixed line and mobile capital expenditure is the core of our investment case, we see other opportunities to win.

Competitive Dynamics
The near equivalent tariff plans across providers and customer churn that is near record lows suggest to us that the three Korean telecommunication companies are focused on returns rather than engaging in aggressive competition.

Regulation
Whilst the Korean regulators have historically been quick to protect the rights of consumers, we’re not sure this could get much worse. We certainly take comfort from the fact that despite the noise generated during the 2017 presidential campaign regarding the need for greater regulation, not much has actually changed.

Management/Financial
Despite a similar margin profile to peers, KT remains a relatively inefficient former government controlled operator with optionality to reduce costs – particularly labor costs – which the current CEO has a history of doing. KT also owns a vast real estate portfolio which on conservative estimates is worth USD8bn, a value in excess of KT’s market capitalization of ~USD7.5bn. By 2020, revenue from its property segment should be around $750m, of which half will be rental income. Furthermore, KT’s 27.6% 2016 dividend payout ratio is well below regional telecommunications company’s best practice, and below the capacity of KT to distribute income. We believe KT’s valuation discount to its peer group could be closed via a more progressive dividend policy with little cost to the net financial risk of the group.

Style/Macro
In a “style” environment where the market remains enamored with growth, low volatility and yield, we find the Telecommunication Sector exhibits at least two of these characteristics, while growth opportunities may be underappreciated. At a time when infrastructure stocks have been celebrated the world over, telecommunications infrastructure, the beating heart of the digital economy, may be vastly underappreciated.

CHART 3: ASIAN TELECOMS EV/EBITDA VERSUS DIVIDEND PAYOUT RATIO

Chart 3_Asian telecoms EV.EBITDA versus dividend payout ratio

Source: Factset

MARGIN OF SAFETY

For its sins of historically over-investing in fixed line prior to earning an economic return whilst also aggressively densifying its 4G mobile network, KT has become one of the cheapest telecommunications stocks globally with an enterprise value (EV) to sales multiple of 0.6x and EV to EBITDA of 2.6x (half the multiple of the Asian peer group) but, more importantly, is also trading on a highly attractive EV to free cash flow yield of approximately 15%.

Further, in a world of low yields, a higher dividend can result in outsized share price appreciation. As detailed in Chart 3, there is strong empirical evidence across listed Asian telecommunication companies that the dividend payout ratio is a critical valuation factor. Based on our analysis of a cross section of regional peers, there is a 53% correlation between “payout ratio” and “EV/EBITDA” ratio.

If KT were to raise its payout ratio to 50% (from the current level of 28%), the shares should command a valuation of around 5-6x EBITDA (the approximate valuation multiple afforded peers with a similar payout ratio), equivalent to W86k or approximately 3x the current share price. Given ample balance sheet capacity and projected strong free cash flow, in our view KT could ultimately sustain a payout ratio closer to 80%, in-line with mature market peers in Taiwan, Malaysia and Australia. Such a payout ratio might correspond to EV/EBITDA valuation multiples of 7-10x, suggesting still further share price upside potential.

In world that is chasing growth in yield and companies that manufacture this by taking on more leverage, the elegance of investing in KT is that this potential growth can be supported by a strong balance sheet and cash-flow generation.