NETLINK NBN TRUST - DBS Research 2017-08-29: Stability And Growth

NETLINK NBN TRUST - DBS Vickers 2017-08-29: Stability And Growth

NETLINK NBN TRUST CJLU.SI

NETLINK NBN TRUST - Stability And Growth

Sole nationwide provider of residential fibre network in Singapore.

Underground passive infrastructure (ducts, manholes and fibre) have long asset life as they are less exposed to weather and other elements that cause wear and tear. Fibre technology used by NetLink Trust (NLT) is largely future proof as bandwidth can be improved by upgrading the active data transmission equipment.

NetLink Trust is yielding 5.8% with close to 92% of the revenue being regulated in nature.

About 80% of the total revenue is regulated under the Regulated Asset Base (RAB) model, whereby NetLink Trust (NLT) will generate fixed returns (pre-tax WACC of 7% from Jan 2018 to Dec 2022).
Projected FY19F total debt-to-EBITDA ratio of 3.2x is conservative versus an average of 5.3x for the Business Trusts in Singapore/Hong Kong and 7.5x for regional developed market utilities and infrastructure plays.
Initiating coverage with BUY, TP of S$0.95.
NLT is yielding 5.8% (FY19F) at current prices and 4.9% at our target price, coupled with DPU growth of 6% over FY18-19F.

WHERE WE DIFFER

We believe the market is concerned that a rising interest rate environment could lead to a higher yield spread in the long term.
We believe that NLT has a solid investment case as its distributions are set to grow at 4.6% CAGR over FY18-20F and in the longer term, benefit from potentially higher regulated returns on the RAB business from 2022 onwards in case of higher cost of debt.

POTENTIAL CATALYSTS

Newsflow on TPG Telecom’s backhaul roll-out leveraging on NLT’s infrastructure in early 2018, and
Widened scope of Smart Nation initiatives as NLT could use its debt headroom to invest in those initiatives, leading to a healthy growth in distributions in the long term.

SWOT ANALYSIS

Strengths

Sole nationwide provider of critical infrastructure used for ultra-high speed fibre broadband to residential customers.
Fully built-out nationwide network subsidised by government grant, affording natural barrier to entry.
Under the Regulatory Asset Based (RAB) model to determine the regulatory pricing, the Trust Group is able to generate additional returns from incremental capex. This, coupled with utility-like nature of broadband, makes the business resilient to economic and business cycles.
While, the accounting life of fibre cables is 25 years and 50 years for ducts and manholes respectively; in practice these assets last much longer especially in Singapore’s case where they are laid underground.
Future-proof with limited substitution risk as fibre broadband is the most efficient technology known so far for transmitting large amounts of data from point-to-point directly at high bandwidth with low latency.

Weakness

The Trust Group has been unable to comply with the Info-communications Media Development Authority of Singapore (IMDA)’s quality of service (QoS) Timeframe Standards leading to financial penalties being levied on NetLink Trust.
High one-time capex projected by Trustee-Manager in FY18 and FY19 primarily to increase the spare fibre capacity to 50% in the residential homes, acquisition of more lead-in ducts and higher co-location space, and the IT project, etc.

Opportunities

High growth opportunity due to consumers’ migration from older technologies to Fibre broadband.
Gain market share in the non-residential wired broadband space.
The second phase of the Smart Nation Programme is likely to deploy an additional 10,000-12,000 Aggregation Gateway (AG) Boxes over ten years, presenting growth opportunities for NetLink Trust’s NBAP connections segment.
Benefit from providing backhaul fibre network infrastructure for wireless initiatives such as Wireless@SG and for mobile operators to roll out their HetNet and 5G networks. NetLink Trust is a logical backhaul partner for TPG, Singapore’s newest mobile operator.

Threats

Financial penalties due to
1. non-compliance with QoS Timeframe standards or
2. delay in the implementation of new IT system, could adversely impact future distributions.
Competitive risks in the non-residential fibre broadband space if more Retail Service Providers (RSPs) decide to deploy their own fibre networks selectively instead of relying on the Trust Group.
The average cost of capital WACC of 7% set from January 2018 to December 2022 may change in the future reviews, potentially impacting the regulatory pricing.
The Trust Group may be unable to refinance its current debt with favourable terms, and is subject to interest rate risk in the longer term.

INVESTMENT SUMMARY

Sole nationwide provider of residential fibre broadband network in Singapore.

The Trust Group’s (the Trust, and its subsidiaries taken as a whole) network is the only fibre network with nationwide residential coverage in Singapore.
As of 31 March 2017, the Trust Group’s network had passed1 substantially all of the 1.4m estimated residential homes in Singapore, and reached 21.3m residential homes. There were approx. 1.1m residential end-user connections supported by the Trust Group’s network as of 31 March 2017, representing ~76.3 % of all residential homes passed.

Long asset life coupled with high entry barriers.

While the typical accounting life of fibre is 25 years, and 50 years for ducts and manholes; however, in practice, industry consultant Media Partners Asia (MPA) believes these physical assets last much longer, especially in the case of the Trust Group, as large components of the fibre network infrastructure are buried underground and therefore less exposed to weather and other elements that cause wear and tear.
The technology is largely future proof as bandwidth can be improved by upgrading the active data transmission equipment, rather than the passive fibre infrastructure itself. MPA estimates that the cost to roll out a similar network to the Trust Group’s is at several billion dollars especially if there is a need to dig access routes and lay ducts.
The Trust Group has benefitted from its access to Singtel’s existing ducts and manholes, coupled with incentives from the government.

Resilient business due to predictable and regulated revenue stream.

Close to 92% of FY17 revenue was regulated in nature, another ~5% was unregulated but contractual in nature (from Central Office) leaving only 3% in other revenue as less predictable in nature. In total, 97% of revenue are regulated or contractual.
A large proportion of the regulated revenue is governed by regulated pricing based on the Regulated Asset Base (RAB) model, allowing the Trust Group to recover:
1. return of capital deployed (i.e. depreciation),
2. operating expenditure, and
3. return on capital employed.
As such, the Trust Group will be able to recover capital expenditure spent as part of the RAB.

Conservative gearing leaves enough room to raise debt to execute future growth strategy.

We estimate the Trust Group to have a conservative total debt-to-EBITDA ratio of 2.3x as of end-FY17 on a proforma basis, and project it to draw down as required on two revolving credit facilities (RCFs) totalling S$300m to fund higher non-recurring capex over FY18 and FY19.
We estimate that total debt / EBITDA ratio will hover around 3.0x at the end of FY20.
The gearing is conservative compared to most Business Trusts in Singapore and regional developed market utilities and infrastructure plays. The prudent capital structure lends the flexibility to refinance existing debt easily and raise additional debt on favourable terms as and when required.

We project residential and non-residential fibre subscribers of the Trust Group to grow at 8.0% and 10.6% CAGR respectively over FY17-20.

MPA projects fibre to comprise 100% of residential wired broadband in Singapore in 2021 versus 82% in December 2016 as older technologies are likely to cease by 2021. Thus, over FY17-20, we expect the Trust Group’s residential fibre subscriptions to grow at an 8.0% CAGR as fibre penetration rises. Meanwhile, we project the total number of non-residential wired broadband in Singapore to show ~7% CAGR over FY17-20 and the Trust Group’s share to rise from ~32% in FY17 to ~35% in FY20, leading to 10.6% subscriber CAGR over the same period.
Non-fibre connections are expected to decline in the corporate segment amidst a rise in the number of small and medium enterprises (SMEs) which may be incentised to utilise the government grants to improve productivity through digitisation and adoption of broadband.

Growth from connected services including Smart Nation initiative and fourth mobile player.

MPA estimates that the total addressable market for Non-Building Address Point (NBAP) connections will grow at a CAGR of 75.6% over 2016-21.
We project the Trust Group’s NBAP connections to grow sharply from 357 at the end of FY17 to around 3,000 connections by FY20. More than 80% of projected increase in connections are likely to be specifically used to support Smart Nation Programme initiatives and the remaining to support the backhaul of fourth mobile player - TPG Telecom.

Offers FY17-20 EBITDA CAGR of 5.9% and intends to distribute 100% of its cash available for distributions (CAFD).

EBITDA growth will be driven by rise in the number of residential and non-residential fibre connections, outweighing the impact of lower regulatory pricing in the residential space from January 2018 onwards.
The Trust Group’s distribution policy is to distribute 100% of its CAFD on a semi-annual basis.

We derive a target price of S$0.95 based on DCF methodology.

We arrive at our target price of S$0.95, representing a ~17% upside from current prices, using WACC of 5.7% (Rf 2.5%, Beta 0.55, Cost of equity 6.4%, Cost of debt 4.0%) and terminal growth of 1.2% to reflect the long-term household formation rate.

VALUATION

We have valued the Trust using a discounted cash flow (DCF) methodology given its consistent, largely regulated stream of cash flows generated from its fibre broadband business, where the number of connections can only go upwards, and there is limited volatility to pricing or cost base. Our equity valuation of the Trust works out to be $0.91/share, based on a Weighted Average Cost of Capital (WACC) of 5.7%.
The derivation of WACC is as follows:
1. Risk-free rate of 2.5% based on Singapore government bond yields
2. Beta of 0.55 (comparable to the beta of other Business Trusts, S-REITs, and select infrastructure plays; see table alongside)
3. Debt-to-asset ratio of 20% based on the Trust’s current prudent capital structure and future plans to remain below 4.0x total debt-to-EBITDA ratio
4. Cost of equity of 6.4%
5. Cost of debt of 4.0% (assuming future rate hikes)
6. Singapore corporate tax rate of 17.0%
7. Terminal growth rate of 1%
Organic growth is likely to decline in the long term as the market becomes fully penetrated, and thus, terminal growth rates are pegged to long-term household formation rates in Singapore. We are not assuming any inorganic growth through acquisitions.
We note that NLT is yielding 5.8% (FY19F) at current prices and 4.9% at our target price, coupled with DPU growth of 6% over FY18-19. This compares with broadband players, Australian infrastructure peers, regional telecom players and top-tier S-REITs.
We also note that the Australian infrastructure peers are highly geared compared to NLT, and hence qualify as riskier assets despite similar long-term cash flow profile.
We also note that Hong Kong-based integrated broadband operator HKBN offers higher return potential in the near term, with a similar balance sheet profile as the Trust. The key difference is that HKBN not only owns passive fibre but also operates active broadband equipment in a competitive residential broadband market and hence, longer term cash flows and technology issues are less predictable.

KEY RISKS

Higher financial penalties due to non-compliance with IMDA’s QoS Timeframe Standards.

IMDA will continue to take enforcement actions against such further non-compliance.
In the residential space, NLT was able to fulfil only 91.1% and 91.5% of all service orders in 2015 and 6M2016 respectively versus 98% target. In the nonresidential space, NLT was able to fulfil only 53.7% of all service orders in 2015 versus 80% target.
The principal reasons for the inability to achieve QoS Timeframe Standards have been
1. an uncoordinated switching process, whereby an end-user switches its RSP without first terminating its connection from its existing RSP, thus requiring the utilisation of an additional fibre connection to activate the new connection.
2. In the event there is insufficient spare fibre, additional fibre has to be installed to the residential home, which may result in delays due to restrictions relating to the contractors’ ability to gain necessary access to premises or delays caused by third parties (end-users, Requesting Licensees and building management).
The principal reasons for the inability to achieve these QoS Timeframe Standards in non-residential space have been:
1. issues in gaining access (caused by end-users, Requesting Licensees and building management) and obtaining approval from building management to carry out fibre installation works,
2. operational issues, and
3. patching and systems issues.
IMDA has largely accepted the Trust Group’s position that these issues, restrictions and delays were caused by third parties and hence the resultant service provisioning delays should not be attributed to the Trust Group. IMDA however has reserved its right to review any such third-party issue, restriction or delay on a case-by-case basis and there can be no assurance that IMDA would continue to adopt the same approach.
IMDA may direct the introduction of a new compensation framework to the Trust Group’s customers, or increase the quantum of existing compensation for failure to meet the service levels prescribed in the Trust Group’s service offers.

The Trust Group faces competitive risks, in particular in respect of its non-residential business.

While the Trust Group has a relatively dominant position in the provision of fibre network infrastructure to residential end-users, there can be no assurance that competitors will not develop their own networks, particularly in certain newer estates or private developments in Singapore.
Additionally, the non-residential fibre network space is already highly competitive, as several entities have laid their own fibre networks in Singapore’s CBD and certain business parks. Many of the owners of these fibre networks are also Retail Service Providers, meaning that they have the ability to offer the full range of connectivity services to their potential non-residential customers, providing them with a competitive advantage.
The regulatory limitations on the Trust Group’s business do not permit the Trust Group to offer active network services, meaning that it must partner with Requesting Licensees in order to serve the nonresidential market. For areas where the Requesting Licensees have their own fibre networks, the Trust Group faces competition.

Change in ICO pricing due to the change in nominal pre-tax WACC.

The ICO price of NLT will be regulated using the RAB model which allows NLT to recover these cost components:
1. return of capital deployed (i.e. depreciation);
2. operating expenditure and
3. return on capital employed.
The return on capital is based on a nominal pre-tax WACC derived using the Capital Asset Pricing Model CAPM approach. The pre-tax WACC for the current review period is set at 7%. However, IMDA may change rate of applicable pre-tax WACC in future period which is also dependent on the capital structure of the Trust Group.
Any downward revision in WACC by IMDA due to any reason, could lead to a change in ICO pricing, which could impact the distributions adversely.

Risks relating to the implementation of its new IT systems and the migration from the systems shared with Singtel.

As required by IMDA, the Trust Group is currently in the process of implementing new IT systems that will cover most of the key operational aspects of the Trust Group. The Trust Group has requested for extensions of the deadline that IMDA had set for the completion of this migration.
When noting that the Trust Group would not meet the prescribed deadline, IMDA indicated that they expect to take enforcement action in connection with the failure to meet the previously-set deadline. The form of this enforcement action is not known as of the Latest Practicable Date, though the Trustee-Manager believes such enforcement action will most likely take the form of a financial penalty payable to IMDA by the Licensee and is expected to be imposed on the Licensee only after the Trust Group has implemented the IT Project.
Any enforcement actions in the future may have a material adverse effect on the financial performance of the Trust Group. Any additional delays in the implementation of the new systems may subject the Trust Group to additional or enhanced enforcement action.

The Licensee’s FBO licence expires in 2034.

There can be no assurance that the FBO licence will be extended beyond this time or, to the extent it is extended, that such extension will be on similar terms.

The Trust Group may be unable to refinance its current debt on favourable terms, and is subject to interest rate risk.

As certain commitments of the Trust Group extend beyond the term of the Trust Group’s current indebtedness, the TrustManager expects to refinance its current indebtedness as and when such indebtedness falls due. There can be no assurance that new funding or refinancing, if needed, will be available on terms that the Trust Group considers favourable, or at all.
Additionally, any increase in the underlying reference rates will increase the Trust Group’s borrowing costs and will reduce cash flows from operations. NLT has entered into a series of pay-fixed-receive-floating interest rate swaps to convert the variable interest rates on its bank loans into fixed interest rates, for a total notional principal amount of S$510m. Accordingly, 100% of NLT’s S$510m bank loan has been hedged.

FORECASTS & ASSUMPTIONS

The key assumptions used in our revenue model are wired broadband penetration in Singapore households and corporates and NetLink Trust fibre market shares in different market segments. Connection and other regulated charges are as per the ICO. Segmental revenues, revenue growth and key assumptions are presented in tabular form below and in the following pages.

Residential fibre business is the biggest segment.

We assume residential fibre end-user connections will grow at a CAGR of 8.0% over FY17-20. This is a factor of
1. continuing growth in penetration of fibre broadband as a percentage of residential wired broadband connections, from 82% in FY17 to 98% by FY20, owing to migration of end-users from old technology to fibre, and
2. organic household growth in Singapore.
As a result, residential fibre business revenue is projected to grow at a CAGR of 6.1% over FY17-20.
Residential connection charges have been revised downwards from S$15 per month to S$13.80 per month in the 2017 ICO pricing review (which will be applicable from 1 January 2018) and the full-year impact of this will be felt in FY19/20, thus revenue growth in the period will lag subscriber growth to an extent.

Non-residential fibre business expected to grow faster.

The non-residential (corporate) wired broadband market is expected to expand at a 7.3% CAGR over FY17-20, driven by increases in connections from small & medium sized businesses (SMEs), government grants to promote productivity through digitalisation and increasing demand for high bandwidth enterprise applications.
The Trust Group had a market share of around 32% of this market at end-FY17, and we expect this will increase to around 35% by FY20, owing to its superior nation-wide reach, despite more competition in this segment.
Overall, we project the Trust’s subscriber numbers in this segment to increase at a CAGR of 10.6% over FY17-20, and segment revenues to grow at a 16.1% CAGR over the same period, as a result of upward revision in connection charges for this segment in the 2017 ICO price review.

NBAP connections will grow sharply but revenues not material yet.

NBAP connections are expected to grow sharply from 357 at the end of FY17 to around 3,000 connections by FY20, as more sensors are deployed under the Smart Nation initiatives in Singapore, coupled with likely demand from the fourth telco operator in Singapore as well as requirements for HetNet base stations.
Revenue is expected to grow fourfold from about S$0.5m in FY17 to S$2.1m by FY20, but given the small base, it is not material to overall revenues.

Other revenue segments.

Under the fibre business, projections for other lines of revenue is as under:
- Segment Fibre connections revenue: The number of segment fibre connections is affected by efforts from existing Requesting Licensees to improve their network configurations and demands from new Requesting Licensees who need to establish their networks, which would require connections to the Trust Group’s network. We project a slight decrease in segment fibre revenue beyond FY17 owing to the lower revised ICO prices for segment fibre.
- Co-location revenue: Growth in co-location revenue is based on the increased utilisation of co-location space by Requesting Licensees, which in turn is a function of the overall end-user demand for fibre connection services.
- Installation revenue: Growth in installation revenue in the near term is driven by the continuing increase in residential end-user connections, non-residential end-user connections and NBAP connections, and the introduction of new service activation charges of S$53 per connection for residential connections and S$64 per connection for non-residential and NBAP connections from 1 January 2018. While installation revenues, especially from the residential sector will decline in the medium term as homes reached approaches 100% of homes passed over the next five years, activation charges will continue to drive revenue owing to expected churn rates of about 1% per month.
- Diversion revenue: This is a non-regulated revenue item that is derived from ad-hoc income from fibre diversion works requested from third parties like the Land Transport Authority of Singapore during construction of new subway lines in Singapore.
- Ducts and manhole services revenue: This is derived solely from provision of services to Singtel under a fixed agreement, and thus, expected to remain largely stable over time.
- Central Offices revenue: The revenue is derived from the leasing of certain spaces in the Trust Group’s Central Offices and provision of certain ancillary services to Singtel pursuant to leases with Singtel.

The key expenses items are summarised below:

Operation and maintenance costs: Operation and maintenance costs comprise maintenance expense for ducts and manholes, fibre and Central Office as well as co-location expense and warehouse management fees. Maintenance expense is projected to increase in FY18 owing to additional government licensing fees payable for providing fibre services to Marina Downtown Area in Singapore and costs associated to the opening of Hougang Central Office in the preceding year. Co-location expense is also expected to increase in FY18 as the Trust expands its co-location space in anticipation of additional demand from existing Requesting Licensees. Beyond FY18, operation and maintenance costs are expected to grow at inflation rates.
Installation Costs: This is driven by increase in residential enduser connections, non-residential end-user connections and NBAP connections and can be expected to be in line with increase or decrease in installation revenues.
Depreciation & Amortisation costs: Depreciation is calculated using a straight-line method to allocate the depreciable amounts of property, plant and equipment over their estimated useful lives, which range from 5-50 years. Amortisation of license fees is on straight line basis over 23 years and amounts to around S$10m per year. The depreciation and amortisation charges of course are non-cash items and will have no impact on distributions.
Staff costs: Staff costs are expected to increase sharply between FY16 and FY19 owing to additional headcount to implement an ongoing IT project to migrate away from systems previously shared with SingTel. Projected staff costs could normalise in FY20 and beyond once the IT project is completed.
Other Operating Expenses: Other operating expenses include property tax, IT cost, licence fees, professional fees, insurance cost and rental expense. The step-up expected in FY18 is again due to higher projected IT costs owing to the ongoing project mentioned above. These projected costs can also be expected to normalise beyond FY19 once the project is completed. Property tax – calculated at 10% of 5% of the sum of the Trust’s fibre, duct and manhole assets – is likely to grow in line with gross fixed assets.

DISTRIBUTION SUMMARY

Semi-annual distribution policy.

Distributions by the Trust will be made on a semi-annual basis, with the amount calculated as at 31 March and 30 September each year for the 6-month period ending on each of the said dates. However, the Trust’s first distribution period will be for the period from the formation of the Trust to 31 March 2018. Subsequent distributions will take place on a semi-annual basis.
The Trustee-Manager will pay the distributions no later than 90 days after the end of each distribution period.

Distributions are likely to be steady and predictable.

The Trustee-Manager intends to provide long-term, regular and predictable cash distributions from the business. The sub-Trust NLT’s distribution policy is to distribute at least 90% of its Distributable Income to the Trust.
The Trust’s distribution policy is to distribute 100% of its Cash Available for Distribution (CAFD).

QPDS interest payments and capital allowances will allow for tax savings.

NLT will issue to the Trust S$1.1bn (@10.5% fixed interest rate p.a.) in principal amount of the NLT Notes, which will qualify to be qualifying project debt securities (QPDS) under section 13(16) of the Singapore Income Tax Act and hence interest expense is tax deductible at NLT level and the interest income received by the Trust from the NLT Notes will be exempt from tax.
Given that distributions received by the Trust from sub trust NLT will include the QPDS interest payments, there will be substantial tax savings.
In addition, owing to capital allowances accruing in the near term from the non-recurring capex in FY18/19, we expect there will be no cash tax incurred by the Trust in FY18-20.

Distributions will benefit from rise in EBITDA and decline in capex in medium term.

The Trust Group’s EBITDA is projected to grow at 5.9% CAGR over FY17-20. Capex to revenue ratio in FY18/19 is projected to be high at 30-50%, but is projected to decrease to steady state levels of around 15% by FY20, which will free up more cash for distributions.
However, the Trust is also projected to incur cash tax expenses beyond FY20, once the capital allowances are not enough to offset taxable income, which will temper the distribution growth to an extent beyond FY20.
Overall, we project annualised distributions of S$170m, S$180m and S$186m in FY18/19/20F respectively.

Sachin MITTAL DBS Vickers | Suvro SARKAR DBS Vickers | Singapore Research DBS Vickers | http://www.dbsvickers.com/ 2017-08-29

DBS Vickers SGX Stock Analyst Report BUY Initiate BUY 0.95 Same 0.95