StarHub - CIMB Research 2018-01-16: Still Not Enough To Reach The Stars

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STARHUB LTD CC3.SI

Starhub - Still Not Enough To Reach The Stars

• We like the prospects of StarHub’s Fixed Network Services (FNS) business, with growth to be accelerated by the recent acquisition of Accel Systems & Technologies Pte Ltd (ASTL) and the proposed purchase of D’Crypt.
• However, we still expect EBITDA/core EPS to fall 12%/36% over FY16-20F as FNS growth will not be able to offset mobile, pay TV and broadband revenue declines.
• More FNS-related acquisitions are possible but any potential boost to earnings will be limited by how much it can invest, amongst other factors. 
• The degree of mobile competition after TPG’s market entry will still likely have a bigger impact on StarHub’s earnings outlook in FY19-20F.    

Share price rally on FNS excitement led by M&As 

Share price rise on promising FNS revenue growth… 

• StarHub’s share price has risen c.16% since its low of S$2.52 in mid-Aug 2017, with much of the upward move coming after with the release of its 3Q17 results in early-Nov. 
• During the quarter, fixed network services (FNS) revenue registered a promising 11.3% yoy (+10.4% qoq) jump, although its positive impact on overall earnings (-11.4% yoy, -11.1% qoq) was masked by lower NBN adoption grants (as expected) and higher depreciation and 4G spectrum fee amortisation.

… boosted by the acquisition of ASTL in Jul 2017 

• The jump in StarHub’s FNS revenue in 3Q17 was partly due to the completion of its acquisition of an 80.4% stake in Accel Systems & Technologies Pte Ltd (ASTL) for S$31.1m (before deferred consideration) in mid-Jul 2017. 
• ASTL is a cybersecurity consultant and solutions provider, which StarHub acquired to expand its suite of cybersecurity solutions to enterprise customers. ASTL contributed c.S$7m to StarHub’s FNS revenue in 3Q17, or a boost of c.7% yoy (with the remaining c.4% yoy from organic growth).

… followed by proposed acquisition of D’Crypt in Dec 2017 

• The acquisition of ASTL was followed by StarHub entering into an agreement in mid-Dec 2017 to acquire a 65% stake in D’Crypt Pte Ltd for S$57.5m (with the option to acquire the entire 100% stake for a total maximum of S$122m).
• In its press release, StarHub said the proposed acquisition will enhance its solutioning capabilities in areas such as cryptographic and digital security, secure info-communications technologies (ICT) and Internet of Things (IoT); these are areas vital to Singapore’s vision of a robust, secure Smart Nation platform. 
• Established in 2000, D’Crypt services clients in the military, security and government sectors across the globe. D’Crypt’s largest project to date is the d’Cryptor ZE, the computational and security core in the Electronic Road Pricing (ERP) In-Vehicle Unit, which is currently in use in Singapore’s ERP System.

We like the prospects of StarHub’s FNS business… 

Putting the balance sheet to better use to drive FNS growth 

• Prior to the acquisition of ASTL, StarHub’s net debt/EBITDA (prior quarter annualised) stood at 0.75x at end-3Q17, which is below the 1.0-1.5x that is typically considered as optimal levels for Singaporean telcos.
• Given the challenging future prospects of its mobile, pay TV and broadband businesses, we agree with StarHub’s decision to make better use of its balance sheet by funding acquisitions that will accelerate the expansion of its promising FNS business. Besides ASTL and D’Crypt, we believe there could be more acquisitions in the pipeline to boost the FNS business, possibly in the areas of data analytics and IOT, etc. 
• Our discussions with management suggest that StarHub is likely to diversify its investments rather than make a single large acquisition, such as Singtel’s US$770m purchase of Trustwave.

Healthy FNS revenue growth in FY18-19F 

• We project StarHub’s FNS revenue to grow by a healthy 6.2% yoy in FY17F, then jump 15.9%/7.4% yoy in FY18/19F. This factors in: 
  1. the full-year consolidation of ASTL from FY18 onwards. Based on its 3Q17 performance, we have factored in a revenue contribution of S$14m in 2H17 (with estimated annual revenue of S$25m for FY17). We estimate its annual revenue will then climb by 10% p.a. to S$27.5m/S$30.3m in FY18/19F, which is roughly in line with Gartner/PwC’s projection that the Singapore cybersecurity market is expected to grow at around 9.3% p.a. between 2015 and 2020, faster than the broader IT market.
  2. maiden 9-month contribution from D’Crypt in FY18 and full-year contribution in FY19. There is no information on D’Crypt’s historical or current revenue and earnings. Hence, we have simplistically assumed that D’Crypt’s annual revenue is twice that of ASTL. This is based on
     1. the total equity valuation of D’Crypt (maximum of S$122m), which is 2.6x higher than ASTL (maximum of S$45.6m), and
     2. our belief that D’Crypt’s acquisition price includes a premium for D’Crypt’s R&D team, and not only its current revenue and earnings. This translates into a revenue contribution of S$41.3m in FY18F (9-month impact) and S$60.5m in FY19F.
  3. organic growth of 5% p.a. for its existing fixed network services revenue in FY17-19F.

What will ASTL and D’Crypt contribute in terms of earnings? 

• We estimate ASTL’s full-year net profit to be S$4.5m in FY17F or a net margin of 18% (on revenue of S$25m). This is based on StarHub’s announcement that the Phase 2 acquisition of ASTL includes a deferred cash consideration to be paid to the sellers if ASTL’s aggregate earnings over FY17-18F exceed S$8.4m, which implies an average S$4.2m p.a. We consider this as ASTL’s base-line annual earnings. For FY18F/19F, assuming the same net margin, we project net profit of S$5.0m/S$5.4m. 
• After minority interest (19.6%), ASTL’s net profit contribution is S$2.0m in FY17F (half-year impact), S$4.0m in FY18F and S$4.4m in FY19F.
• For D’Crypt, we have assumed the same 18% net margin as ASTL. Based on our revenue projections, this translates into a net profit of S$10m in FY18F and S$11.0m in FY19F. After minority interest (35%), net profit contribution in FY18F and FY19F are S$4.9m (9-month impact) and S$7.2m, respectively.

Acquisitions structured to manage downside risks 

• There are risks that StarHub could make the wrong acquisitions or overpay. However, we see several mitigating factors: 
  1. the acquisition of ASTL and proposed purchase of D’Crypt are to be executed in several phases, spanning over three years, with the purchase consideration structured to incentivise the delivery of medium-term financial milestones (or adjust for shortfalls with clawbacks). For example, StarHub will initially acquire a 65% stake in D’Crypt in 2018 (Phase 1) for S$57.5m. The remaining 35% stake will only be acquired in 2021 (Phase 2) for a maximum cash consideration of S$64.5m, with the final amount determined using a formula primarily based on the audited EBITDA for FY18-20 (and new orders received in FY20 that will contribute to estimated earnings in FY21-25); 
  2. ASTL and D’Crypt are companies that StarHub is acquiring to enhance its cybersecurity and Smart Nation capabilities, two areas in which we expect to see healthy growth in demand from enterprises and the Singapore government in the coming years; and 
  3. the management teams of the acquired companies have strong credentials and the track record of having won significant Smart Nation contracts from the government. For example, D’Crypt is led by Defence Technology Prize winner Dr Antony Ng and its largest project to date is the d’Cryptor ZE, the computational and security core in the Electronic Road Pricing (ERP) In-Vehicle Unit, which is currently in use in Singapore’s ERP System. Meanwhile, we understand from StarHub that the engineers at ASTL have received Tier-1 (highest) security clearance from the Singapore government and are therefore qualified to tender for government projects.

… but the overall earnings outlook is still down 

Forecasts raised but EBITDA to still decline by 12% in FY16- 20F 

• We have raised our FY17/18/19F EBITDA by 3.6%/2.9%/8.1% after: 
  1. including earnings contribution from ASTL and D’Crypt in FY17-19F 
  2. deferring the negative revenue impact from TPG’s entry by 6 months to FY19F onwards (previously, from mid-FY18F) as we expect TPG to launch its service only at end-FY18F. 
• We maintain our view that mobile ARPU will be affected by a total 10% post TPG’s entry. However, our net profit estimates for FY17-18F are cut by 2.5-3.1% as we have factored in higher depreciation and amortisation charges after 3Q17 and raised our net profit estimates only in FY19F by 4.5%.
• Post our revisions, we expect StarHub's EBITDA to still decline by 11.6% between FY16 and FY20F, which is the year we expect earnings to bottom out. 
• For net profit, we expect it to fall by 35.6% in FY16-20F.

FNS still not big enough… 

• Although we are positive on StarHub’s recent acquisition of ASTL and D’Crypt to boost its FNS business, their net profit contribution is unlikely to be that substantial, i.e. we estimate an aggregate S$8.9m/S$11.6m/S$13.3m in FY18F/19/20F after minority interest. While this will certainly help to buffer the negative impact from TPG, it is insufficient to alter the course of StarHub’s declining earnings trend in the next few years, in our view. 
• At about a quarter of total service revenue by FY20F (FY17F: 19%), the healthy 37.4% cumulative growth in FY16-20F in overall FNS revenue will not be able to fully offset declining revenues at its mobile, pay TV and broadband business that make up the balance three-quarters of its revenue.

… to offset the decline in mobile, pay TV and broadband 

• We are projecting a 0.9% decline and 1.4% rise in mobile service revenue in FY17F and FY18F, respectively. While we do see slightly raised competitive pressure from the entry of more MVNOs into the market in FY18 and a continued decline in roaming revenues, we believe that this will be offset by StarHub’s S$5.10/month subscription fee hikes implemented (upon contract renewals) across its postpaid plans in Sep 2017. We then expect mobile revenue to fall by 2.7%/5.8% in FY19/20F, driven by more intense competition arising from TPG’s market entry by end-2018. 
• Overall, over FY16-20F, we expect mobile revenue to decline by a cumulative 7.9% and its contribution to total service revenue to fall from 55% to 52%.
• We see pay TV revenue declining further, down a cumulative 23.0% over FY16- 20F, on the back of a diminishing subs base due to substitution by alternative viewing platforms and piracy. 
• Meanwhile, we expect broadband revenue to decline by 4.2% in FY16-20F on gradual subs market share loss to newer players, including TPG, which is likely to enter the residential broadband market following its mobile service launch.

DPS of S$0.16 sustainable but unlikely to rise in FY18-20F 

• We believe StarHub’s current DPS of S$0.16 is sustainable across FY17-20F.
• We see its net debt/EBITDA rising from 1.2x at end-FY17F to a still-manageable 1.5x at end-FY20F. This already factors in S$282m payment for the 700MHz spectrum in mid-2018, which could actually be paid later if the use of the spectrum is deferred beyond Jan 2019 (due to possible delays in analogue switch-off in neighbouring countries, especially Indonesia).
• However, at the same time, we think there is little room for StarHub to raise DPS beyond S$0.16. Besides already fairly optimal net debt/EBITDA by end-FY20F, StarHub is likely to conserve some cash for future M&As in the FNS space and as a cash buffer in case competition from TPG is worse than expected.

Scenario analysis on earnings outlook 

What if StarHub makes more acquisitions? 

• StarHub may acquire more companies in the FNS space in the coming months that could gradually add to its earnings. However, we think any earnings boost arising from this will be somewhat limited by how much the telco is willing and can afford to spend on M&As. So far, for ASTL and D’Crypt, it has committed to a maximum investment of S$167.6m in FY17-21F. 
• Assuming it does not want to exceed 2x net debt/EBITDA anytime over FY17-20F, we believe StarHub may have room in the balance sheet to invest up to a further c.S$300m. Assuming an acquisition P/E of 10x, it could mean buying companies that generate aggregate S$30m in net profit. After interest cost (3-4%) to fund such acquisitions, net profit could see accretion of c.S$20m.

What if mobile competition is better or worse than expected? 

• Currently, we assume a cumulative 10% impact on StarHub’s mobile ARPU in FY19-20F from TPG’s market entry. 
• In the bull case, if the cumulative impact is only 5%, then its EBITDA/net profit will decrease by a lower 4.4%/23.6% in FY16-20F. 
• In the bear case, if mobile ARPU is impacted by a cumulative 15%, EBITDA/net profit will drop by a more substantial 18.6%/47.4% over the same period.

Maintain HOLD with 12% higher Target Price of S$2.80 

FNS growth outlook may be exciting but current share price seems fair 

• We have raised our DCF-based target price by 12% to S$2.80 (WACC: 7.1%).
• This is after
  1. fine-tuning our opex and capex assumptions to avoid the risk of being overly-conservative,
  2. including the potential value creation from its recent acquisitions, and
  3. deferring the negative impact from TPG’s market entry to FY19F. 
• Despite that, our revised DCF-based target price suggests a potential 4.1% downside from the current StarHub share price, although this is compensated by a dividend yield of 5.5%. 
• With a net positive return of only 1.4%, we maintain our HOLD rating. 
• A good entry point is below S$2.50 (bear-case target price) and exit point above S$3.10 (bull-case target price).

Consensus forecast may be too low, though 

• For investors that believe our bear-case scenario of a 15% impact on mobile ARPU is the more likely route, StarHub may look like a short at its current share price. While the bear case is certainly possible (we have designed our scenario analysis to be realistic), we would like to highlight that StarHub’s FY17-18F earnings may come in higher than consensus forecast, which is a bit too low, in our view. 
• We believe our FY17-18F EBITDA/net profit projections are higher than consensus due to a few reasons:
  1. iPhone subsidies may not be as high due to lower-than-expected sales volumes,
  2. consensus may not have factored in the earnings contribution from ASTL and D’Crypt due to lack of information on their financials, and
  3. postpaid subscription fee hikes since Sep 2017 may not have been fully reflected in consensus earnings estimates.
• If we are right, consensus earnings estimates and target prices of StarHub may be revised upwards in the next few quarters, which could suggest that there are few shorting opportunities at this time.

FOONG Choong Chen CFA CIMB Research | http://research.itradecimb.com/ 2018-01-16

CIMB Research SGX Stock Analyst Report HOLD Maintain HOLD 2.80 Up 2.500