StarHub (STH SP) - Maybank Kim Eng 2017-09-13: War On Two Fronts

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STARHUB LTD CC3.SI

StarHub (STH SP) - War On Two Fronts

We initiate coverage with a SELL rating 

• StarHub’s wireless and pay TV businesses are under siege from a new entrant for the former and piracy and changing viewing habits for the latter. Its bundled/”hubbing” strategy remains a strong subscriber retention tool but revenue leakage remains a risk. 
• Stock has de-rated but we believe there is still a leg down. Based on our forecast FCF, the current SGD0.16 per share DPS which has been committed by management can only be supported through additional borrowings.

Dual squeeze 

• We have assumed the industry will see significant margin pressure from handset subsidies to pre-empt TPG’s wireless launch. 
• Meanwhile, pay TV is seeing erosion due to competition and content piracy thanks to the pervasiveness and quality of fixed broadband in Singapore. We assume wireless service revenue will decline at a 3-year CAGR of 2%, and 7% for pay TV.

Enterprise business equalizer 

• StarHub is aiming to leverage its track record in managing the data network of its legacy cable assets into the fibre broadband space in order to increase its share of the local enterprise market and win projects from the SGD2.4b Smart Nation initiatives. 
• We forecast the division’s revenues will grow at a 10% 3-year CAGR, which should help cushion the downside in other parts of the business.

Still some ways to go 

• We believe margin pressure from subsidies and/or competition is not fully priced in, despite the 12-month underperformance. Even at our DCF-based target price of SGD2.17 (WACC 5.3%, LTG -1%), the stock would be trading at P/E of 20.7x FY18E, which is a 25% premium (above 1SD) to its 10-year mean of 16.4x. 
• A higher-than-industry yield based on its absolute DPS commitment offers some shelter and can be sustained in the medium-term if management tolerates the higher leverage, while making more potential enterprise investments. 
• Margins being sustained despite increased competition is the upside risk to our outlook.

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INVESTMENT THESIS

Pressure will only increase 

• StarHub’s bundled service (“Hubbing”) strategy has served it well in taking significant share in the wireless (#2), pay TV (#1) and retail fixed broadband (#2) markets in Singapore. All three business lines are facing adversity due to competition with the hardest hit to margins, we assume, will come from wireless due to higher handset subsidies albeit with lower revenue erosion relative to pay TV. 
• At this stage we believe operationally things can only get worse and that consensus forecasts have not fully accounted for these prospects. Wireless and fixed broadband are hurt by increased local competition in high penetration segments, while pay TV is being impacted by changes in viewing habits and overseas pirated content. We estimate that EBITDA margins will drop to 22% in FY18E from 29% in FY16 from the combination of revenue pressure and rising subsidy costs.
• Bright spot for growth opportunities for StarHub and the industry is the enterprise segment which includes potential contracts from the government’s Smart Nation initiatives. They may all be competing for the same space but it is a growing source of revenues relative to the wireless and fixed broadband carriage markets. Company has invested in networks and human resources to increase capabilities and relationships for this purpose. Consequently, we forecast fixed network revenues will grow at a 10%, 3-year CAGR as the company gains some share on SingTel.
• We forecast core profits will decline at a 3-year CAGR of 13% despite a virtually flat (-0.1%) service revenue CAGR over the same period. Aside from subsidies, this is brought about by increased amortization costs from the recently won wireless frequencies.

Not offering enough value yet 

• Having taken a 24% tumble on a 12-month basis and offering a 6% dividend yield for FY17E, the stock is likely appearing in some value screens but we caution that value has yet to emerge. Consensus EPS forecasts are subject to downside risk and imply 18.5x and 24.8x P/E for FY17E and FY18E (EPS falling YoY). 
• At our DCF-based TP of SGD2.17/sh (WACC 5.3%, TG -1.0%, beta 0.6), StarHub would still trade at a P/E of 20.7x on FY18E EPS, which is over one standard deviation above its 5-year and 10-year historical mean P/Es.
• The dividend yield of 6.1% FY17/18/19E admittedly looks attractive against its 5-year and 10-year averages of 5.3% and 6.4%, respectively. However, industry risk was lower in the past and debt levels are rising with FCF insufficient to support the dividend in FY17/18E, and both the dividend and capex in FY19E, based on our forecasts. 
• With our net debt to EBITDA forecast peaking at 2.3x in FY19E, the current payout commitment of SGD0.16 per share can be supported in the medium-term, despite weak free cash flow. The payout ratio was over 100% during 2009-2011, and since 2013 dividends have exceeded free cash flow generation. 

Risk 

• If the industry manages to re-contract the largely postpaid subscriber base without significant subsidy escalation, there could be upside to our target price and outlook. Low subsidies due to low re-contracting success would naturally not be welcome and jeopardize future revenues from potential tariff competition.
• An escalation of fixed network revenues to drive overall service revenue growth vs our current assumption of a virtual standstill would also present upside risk. This would seem to have a higher chance of taking place than a tame competitive environment scenario on the wireless front.
• With its relatively high dividend yield attracting investor interest in the stock, any threats to its cashflow could de-rate the shares further. Management has emphasized that it is prioritizing maintaining the dividend commitment of SGD0.16 per share by increasing leverage, despite potential acquisitions in the enterprise and digital space. 
• As StarHub pays dividends from the company level rather than the consolidated entity there remains adequate (SGD1.40b in 2QFY17) reserves to declare dividends from. Should the parent reserves be significantly diminished the risk of a dividend payout cut will heighten.

VALUATION

DCF benchmark shows further downside 

• We set our target price of SGD2.17 per share for StarHub using a DCF methodology. We believe this more realistically reflects the value of the business during a historically unprecedented period of higher competition from new entrants unlike the three-player market of the past. It also captures the normalization period after the initial repercussions of TPG’s entrance over FY17E-19E. 
• Note that our FY19E EBITDA forecast of SGD610m remains below the level in FY16A of SGD690m.
• Downside catalysts in the next 12 months could come from:
  1. significant subsidy cost escalation – which can be partially gleaned from the new Samsung and iPhone model launch queues; and/or
  2. the actual launch of MyRepublic’s mobile MVNO plans and TPG’s wireless and fixed broadband service. 
• On the other hand, further downside in pay TV revenues may be an expected event and StarHub has been managing the decline.

Trading valuations are far from cheap 

• StarHub is currently trading at 18.6x calendar FY17E, which is near its 5-year mean but closer to 1SD above its 10- year mean. With profits falling in FY18E, the shares are trading at 24.9x calendar FY18E, which is greater than 1st dev above the 5-year mean and even further above the 10-year mean. 
• Despite our projected profit recovery in FY19E, the calendar P/E at 20.1x remains elevated at 1 SD above the mean for both the 5 and 10-yr means. The 10-year average is the more appropriate benchmark, in our view, as it would capture a period of greater competition between the three incumbents; particularly the period where unlimited 3G data plans suppressed industry revenue growth.
• The dividend yield has averaged 5.3% and 6.4% over a 5-year and 10-year period, respectively. This places the current 6.1% yield at a fair level historically, but given an increasing competitive risk environment a premium is justified. If profit weakness sends jitters to the market regarding the sustainability of the fixed DPS payout this could be another downside catalyst. 
• On our forecasts and the company’s loan covenants, such payout remains sustainable assuming the company accepts leveraging up to maintain it. To sustain it at the current commitment involves paying out more than 100% of income and free cashflow, which it has done in the past. As we forecast gearing will peak in FY19E, the risk dissipates but competition and potential acquisitions could change that.
• StarHub trades at premium valuations to peers on a FY18E P/E and EV/EBITDA basis. The premium to M1 is partly merited due to StarHub’s more diversified earnings base and higher dividend yield, but SingTel offers more geographical and business segment risk diversification, and as such the gap should close as our target prices are realized, in our view.
• Based on our SELL recommendation, we expect a further de-rating of StarHub, with a potential re-rating of Singtel as the financial performance diverges and investors rotate.

Not a value stock even at our target price 

• At our target price and profit forecasts, StarHub is reasonably valued based on its current 12M FWD P/E, trading at 18.6x or 1stdev below its 5- year mean P/E and just below its 10-year mean. However, for FY18E where we forecast a steep 25% profit drop in EPS (28% drop FY17E), the target multiple rises to 24.6x, which is 1stdev above its 5-year and 10-year historical mean P/Es. Assuming all our Singapore telco target prices are realized, StarHub would then trade similarly to SingTel.
• The stock on a dip admittedly looks attractive against its 5-year and 10- year dividend yield averages of 5.3% and 6.4%, respectively, but we note those were valuations recorded at times of lower market risk. As we move into a more challenging phase for the wireless and pay TV industry in Singapore, a premium should be expected rather than a return to the mean.

Materially below consensus particularly in FY18E 

• Our EBITDA and core profit forecasts are significantly below consensus, particularly for FY18E when we believe the bulk of re-contracting costs will be recorded. Our higher-than-consensus revenue forecasts for FY18E are likely driven by the increased handset sales and perhaps higher fixed network revenue assumptions.
• Part of the profit drag in FY19E against a relatively flat EBITDA is our assumption that the amortization and finance costs related to the payment for the 700Mhz spectrum fees will commence by then. We are not aware whether consensus has assumed similar circumstances and timing.

Risks 

• The upside risk to our forecasts and target price is a resurgence in wireless service revenues in spite of the emerging competition. However, even without new competition StarHub’s wireless revenues have been declining since FY15 largely due to wireless data cannibalization and increased availability of WiFi hot spots islandwide. 
• The launch of higher priced but more generous data allocation plans (including unlimited data on weekends) could help revenues if competition does not up the ante. Every 1% change in wireless revenue for FY17E would result in a 2% change in our core profit forecasts (2.9% in FY18E) and 2% in target price.
• Another upside risk is that equipment subsidies do not increase as materially as we forecast due to high demand enabling operators to actually reduce subsidies on a per unit basis. 
• On the other hand, if low subsidies are driven by low demand and low re-contracting rates this would leave room for new entrants to poach from StarHub and other incumbents.
• Lastly, fixed network revenues driven by enterprise and IT contracts being better than our current assumptions of a 10% 3-year CAGR would be a potential upside risk. With growing corporate demand and a supply provided by Smart Nation this would be the upside risk we cannot discount in the medium to long term. Every 5% increase in fixed network revenues from FY17E onwards would increase our FY17E and FY18E core profits by 4% and 6% respectively, and would enhance our target price by 5%.

COMPANY BACKGROUND

• StarHub is the second largest wireless operator in Singapore with c31% wireless revenue market share and the largest pay TV operator with 58% revenue market share. As a virtual monopoly for pay TV (via cable) until SingTel’s entry in 2007, StarHub had the head start in a bundled service strategy for subscriber recruitment and retention. This has enabled StarHub to hold its incumbents’ wireless revenue market share relatively stable and we forecast this share will grow slightly going forward, partly as a result of SingTel seeing revenue pressure on its part from more wireless data and WiFi cannibalization on its subscriber base. 
• Although content piracy is eroding the value proposition of pay TV globally, we believe the bundled service strategy still has much efficacy and longevity in Singapore as a retention strategy as households still value the discounts provided through the cross subscription of services.
• Similar to its peers, StarHub has seen wireless data usage across its subscriber base grow to such a point that they increasingly break through their wireless data allocation. With subscribers on tiered data plans slowing in growth due to high market penetration, increased monetization of existing subscribers is the key to revenue growth. 
• Unfortunately with MyRepublic and TPG prospectively around the corner potentially offering more generous and perhaps a return to unlimited data plans, the prospects for better yields seem dim in the medium-term.

ESTIMATES / FORECASTS

• We forecast a continued, but not precipitous, decline in ARPUs and subscriber base on the assumption that re-contracting efforts are effective. The proportion of wireless data will continue to rise as more subscribers use OTT apps that substitute for voice and SMS along with video streaming, gaming and/or content downloads. 
• It is worthy to note that despite an increasing trend of subscribers using past their data ceilings that postpaid ARPUs since 2015 have continued to decrease. This is likely partly due to the prevalence of multiple SIMs per user bringing down the average but also due to voice, SMS and roaming being cannibalized by data StarHub (and SingTel’s) pay TV businesses are under increasing attack from changing viewer habits and morals. 
• Pirated content from streaming services or even individuals out to “share” rather than for economic gain is leading to net disconnections over recent quarters. In May 2017, a Channel NewsAsia article cited a Muso Global Piracy report that Singapore ranked ninth globally in terms of visits to piracy sites as a ratio to the country's Internet population. 
• The pace of disconnections and the management of the ARPU to a soft glide path are laudable, particularly in light of the company having forsaken English Premier League (EPL) content to SingTel since 2010. Nonetheless, the efforts are delaying the inevitable change that is taking place with consumer behaviour. There has yet to be any major regulatory or legal action to curb the behaviour. We forecast pay TV revenues will drop at a 7% CAGR over a 3-year period.
• To differentiate itself and retain local subscribers, StarHub collaborates with and has invested in what is now a c10% stake in local content producer and regional cinema operator mm2 Asia (MM2 SP, Not Rated). Whether this leads to further investment and equitized earnings or even consolidation is not a certainty but remains an option.
• All telcos are gunning for the enterprise segment and in terms of positioning StarHub has data network management experience from its cable broadband and fibre broadband nationwide networks that can be carried over to a more micro corporate data environment. 
• StarHub has been securing corporate contracts to provide back-up system to SingTel and is working on more contracts as a primary service provider. It has taken a SGD19.4m, 51% stake in cyber security system integrator Accel Systems in Jun 2017 to strengthen its capabilities in the growing field. 
• To showcase its capabilities to contribute to Smart Nation initiative projects and its cyber security and data analytics systems, the company launched its 58,000sf “Hubtricity” innovation centre and “converged command cockpit” in Mar 2017. With the volume of projects from Smart Nation and corporates increasingly turning to more managed services to increase efficiency, we have assumed the incumbents, including StarHub, will see positive fixed network revenue growth despite increased competition for work in the space. 
• We forecast StarHub’s fixed network revenues will grow at a 10% CAGR over three years and effectively take some market share away from SingTel in the segment.
• We estimate opex will grow at a 2% CAGR over three years but with a bump up in FY17E and FY18E as a result of higher handset subsidies before this tempers down in FY19E. Our depreciation and amortization and cashflow forecasts assume the cost (SGD282m total) of its 700Mhz spectrum won during the recent GSA beginning in FY19E.
• We assume a 14% to 15% capex-to-sales ratio over FY17E to FY19E with the escalation due to network upgrades for both wireless and fixed network capabilities. The former to maintain a network quality edge to prepare for increased competition and the latter to enhance its abilities to win more enterprise contracts. This could also take the form of more acquisitions to build scale in the enterprise space. 
• Our capex forecast above does not include the upfront cost of the 700Mhz license fee but we capture this for FY19E in our cashflow forecasts via intangible assets that are subject to amortization. Even with this more aggressive capex assumption, StarHub’s balance sheet is capable of sustaining its SGD0.16 per share minimum cash dividend commitment; at least in the medium-term. 
• Whether management will be comfortable with the higher gearing entailed by such is another matter. StarHub’s debt covenants and cash dividend declarations are based on the financials of the parent company, where there is adequate capital and reserves to declare dividends, rather than the consolidated, listed entity.

Luis Hilado Maybank Kim Eng | http://www.maybank-ke.com.sg/ 2017-09-13

Maybank Kim Eng SGX Stock Analyst Report SELL Maintain SELL 2.17 Down 2.360