NetLink NBN Trust - OCBC Investment 2018-03-14: A Safe Haven Amid Volatilities (Part 2 ~ Valuation & Key Risks)

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NETLINK NBN TRUST CJLU.SI

NETLINK NBN TRUST - A Safe Haven Amid Volatilities

Part 2: Valuation & Key Risks

KEY RISKS

• Any of the events or conditions below, besides others not mentioned here, could materially and adversely affect the business, financial condition and results of operations of NLT NBN.

1. NLT NBN operates in highly regulated conditions which may be subject to fluctuations 

• NLT NBN’s primary regulator is the IMDA, which has the discretion to modify terms on which the Mandated Services are provided and review prices charged. In addition, the annual licence fee that NLT NBN pays to IMDA under its FBO licence is subject to review and revision, which can potentially have a material adverse impact on the financial performance of NLT NBN. IMDA also has the discretion to introduce a new compensation framework to NLT NBN’s customers, or increase the existing compensation for failure to meet prescribed service levels.
• Moreover, the IMDA can direct its licensees to co-operate and share any infrastructure owned by them if deemed to be in the public interest – this could be on terms which may cause the NLT NBN to incur costs that may not be fully recoverable. This may also result in interruption to operations and services and a diversion of telecommunications resources for other purposes as mandated.
• The NLT NBN’s FBO licence expires in 2034, and there can be no assurance that the licence will be extended or renewed, or, if extended or renewed, as per similar terms currently. NLT NBN must ensure compliance with various legislation, regulations and codes of practice – these are subject to potential regulatory changes and/or other Singapore government intervention which may result in increased compliance cost.
• Laws and regulations (including future policies, ministerial decisions, regulatory outcomes), changes in the policies and practices of the Singapore government and regulators, and new political and policy developments may impact market conditions unexpectedly or adversely. This, in turn, could have a material negative impact on the operations and financial performance of NLT NBN.

2. The QoS Standards and certain conditions in relation to NLT NBN’s FBO licence have been subject to non-compliance historically, and potentially in the future as well 

• NLT NBN is required under the terms of its FBO licence and the Telecommunications Act to attain certain minimum Quality of Service (QoS) Standards. OpenNet and CityNet (in its capacity as trustee manager of NLT) had previously failed to meet the QoS Timeframe Standards imposed by IMDA, and expect to continue to face difficulties doing so in the near term. Also, it is possible for IMDA to introduce new QoS Standards, increase the level of existing QoS Standards or change the metrics by which compliance is determined in a manner that is detrimental to NLT NBN. 
• IMDA is authorised to impose financial penalties, issue directions, or adopt other enforcement actions should NLT NBN fail to meet its obligations under its FBO licence apart from meeting QoS Standards. Any financial penalties in the future may have a material adverse effect on NLT NBN’s financial performance and any continued failure to meet QoS Standards could impact NLT NBN’s reputation and overall standing in the market and with its primary regulators, leading up to a possible revocation of NLT NBN’s FBO licence.

3. NLT NBN has no direct material relationship with network endusers and is largely reliant on Requesting Licensees for marketing activities and demand growth for usage of its network 

• NLT NBN’s primary sources of revenue are through the monthly recurring fees paid by Requesting Licensees, who enter into commercial agreements with residential and non-residential end-users to provide fibre broadband services. Hence, demand for use of NLT NBN’s network, and the revenue streams resulting therefrom, is mainly dependent on the activities of the Requesting Licensees / RSPs to expand their own customer bases. However, there is no assurance that the interests of the Requesting Licensees / RSPs will be consistent with those of NLT NBN, or that the marketing activities will be successful.

4. Changes in local economic conditions may have a material adverse impact on the financial performance and operations of NLT NBN 

• NLT NBN’s existing business activities are solely in Singapore and demand for use of its network is dependent, among other things, on economic conditions in Singapore. Any economic downturn in Singapore could reduce hiring demand, which could lead to slower growth of the Singapore population as immigration declines. This could lead to a decrease in the growth rate of the number of households, which is a key revenue driver for NLT NBN. Further, any economic downturn could cause conversions to fibre from ADSL or other less advanced connection for certain residential users to slow down, while a decline in commercial activity could cause a decline in demand for non-residential fibre connections. Also, the number of SMEs may decline in line with an overall economic deterioration in Singapore – such businesses are more likely to utilise NLT NBN’s network for fibre connections, as many are located outside of areas that are serviced by NLT NBN’s primary competitors in relation to non-residential fibre networks.

5. Failure of or damage to NLT NBN’s physical infrastructure could result in significant costs and disruptions and, if such disruption is caused by a third party, NLT NBN may not be able to fully recover its remediation costs 

• NLT NBN’s network is susceptible to damage or cessation of operations from fire, flooding, heavy rainfall, other natural disasters, power loss, vandalism, acts of terrorism, cyber-attacks and computer viruses, cable cuts and other events beyond NLT NBN’s control. Damage to NLT NBN’s fibre cables or Central Offices could have a significant impact on the network’s ability to function properly. Underground portions of the network are particularly vulnerable to accidental damage by third parties conducting construction works. As such, in connection with certain failures to meet the service level guarantees specified in the Interconnection Offer, Requesting Licensees are permitted to claim fixed rebates from NLT NBN. While NLT NBN is entitled to recover compensation from these third parties, there is no assurance that these claims will necessarily be successful.
• Also, material network incidents and faults are investigated by IMDA, which has the authority to levy sanctions on NLT NBN, should it be determined that the incident or disruption constitutes a breach of the conditions of NLT NBN’s FBO licence, or any provision of any code of practice or QoS Standards. Any sanction and/or financial penalties may have a material adverse effect on NLT NBN’s financial performance and continued network related issues could negatively impact NLT NBN’s reputation.

6. NLT NBN may be required to incur more capital expenditure than currently expected in order to comply with IMDA’s requirements 

• NLT NBN must ensure that it has sufficient unused network capacity available to most locations within Singapore. NLT NBN is currently laying additional fibre cable to increase the spare fibre network capacity to residential households to at least 50%. However, there is no assurance that this will be sufficient to cater to future demand for the network, that IMDA will not require more anticipatory capacity growth, or that all such excess capacity will be tapped in the future. As such, there might be requirements for unanticipated capital expenditure which could adversely affect NLT NBN’s financial performance and operations materially.

7. NLT NBN faces competitive risks, especially in the non-residential segment of its business 

• There can be no assurance that competitors will not develop their own networks, especially in private or certain newer estates in Singapore.
• Also, the non-residential fibre network space is already highly competitive, with several parties having laid their own fibre networks in certain large business parks and within the CBD. Many of the owners of these networks are also RSPs, who have a competitive advantage by being able to offer the full range of connectivity services to their potential non-residential customers.

8. Technological changes drive NLT NBN’s operating environment 

• Capital expenditure may be required for compliance with any new standards recommended by ITU Telecommunication Standardisation ITET.
• Should such expenditure be unanticipated, there could potentially be a material adverse effect on the financial performance of NLT NBN.
• Furthermore, should NLT NBN be unable to address these new standards successfully and offer competitively, NLT NBN could see an adverse material impact on its operations and financial performance.
• Although not expected in the foreseeable future, parts of NLT NBN’s network may become obsolete as Rapid improvements in technology may require NLT NBN to replace and/or upgrade its infrastructure to remain competitive. Also, there exists substitution risk to the extent that customers choose alternative means of data transmission, such as cellular broadband, including future 5G networks.

9. NLT NBN’s strategy to grow its NBAP business is, in part, reliant on NLT NBN’s exposure to and the successful implementation of the Smart Nation programme 

• The implementation and uptake of the Smart Nation initiative is largely based on exogenous factors, including Singapore government funding and decision making. NLT NBN will be required to effectively manage relationships with, and fulfil the requirements of various Government agencies. Should NLT NBN be unsuccessful in participating in the Smart Nation programme or meeting all necessary governmental agencies requirements, or should the uptake of the Smart Nation programme not be as successful expected, NLT NBN may be unable to attain the level of NBAP growth that it currently envisages, which could impact NLT NBN’s financial performance negatively. Furthermore, as NBAP contribution is a relatively small portion of NLT NBN’s total revenue, there is no assurance as to the future impact of it on the financial performance of NLT NBN.

FINANCIAL ANALYSIS & FORECASTS

Net profit after tax more than doubled to S$75.7m in FY17 on the back of a 16.3% increase in revenue 

• NLT’s FY17 revenue increased 16.3% y-o-y to S$300.1m. This was mainly due to an 18.9% increase in fibre business revenue from S$214.5m in FY16 to S$255.0m in FY17, with broad-based revenue growth from residential and non-residential connections, NBAP connections, segment fibre connections and diversion revenue. These more than offset the 48.9% drop in other income in FY17, resulting from a decrease in interest earned from the reduced cash balances following the cash distribution of S$80.0m to Singtel on 1 Jul 2016 and the recovery of expenses from third parties due to over-accrual of income for FY16.
• Operation and maintenance costs increased 13.8% to S$11.6m in FY17, primarily due to rising costs in relation to the operation and maintenance of the network and co-location expenses. Operation and maintenance costs grew as a result of increases in maintenance costs associated with Central Offices and costs associated with maintenance contracts at Central Offices. Co-location expenses increased primarily due to the rental of new co-location rooms in FY17.
• Installation costs increased 19.4% to S$15.2m in FY17 due to higher number of residential and non-residential end-user connections.
• Depreciation came in lower by 4.1% to S$122.7m in FY17, largely due to accelerated depreciation charges for NLT’s IT systems in FY16.
• Staff costs grew 23.0% to S$19.8m in FY17, primarily due to an increase in both the number of employees as well as average wages in FY17 as compared to FY16. Finance costs decreased 7.1% to S$37.7m in FY17 largely due to the refinancing of S$510m outstanding under the ST Facility Agreement on 24 March 2016 with external bank loans.
• Other operating expenses decreased by 10.4% to S$29.3m in FY17. This was partly due to the reversal of an S$4.0m provision made in FY15 owing to a dispute with Starhub that was subsequently settled. The fall in expenses was also due to a decline in project related professional and legal fees, economic consultant fees with respect to the IMDA price review process and one-off consultancy fees, each of which were paid in FY16 with no similar payments made in FY17. These reductions in operating expenses were partially offset by an increase in IT system maintenance costs and higher property taxes resulting from the expansion of NLT’s network.
• After taking into account the aforementioned line-items, and coupled with a 73.6% jump in income tax expenses to S$14.0m in FY17, NLT’s net profit after tax surged 107.1% to S$75.7m in FY17.

Projecting S$170.1m, S$181.1m and S$185.4m in distributions to unitholders for FY18F, FY19F and FY20F, respectively 

• We expect robust growth momentum from NLT NBN ahead. We are projecting its revenue to increase 10.4% to S$330.2m in FY18F as compared to its FY17 pro forma revenue of S$299.2m. Thereafter, revenue is forecasted to rise 4.0% in FY19F to S$343.2m and 5.8% to S$363.0m in FY20F. This forecasted growth is expected to be driven by higher penetration rates, as we project penetration rates for residential fibre end-user connections as a percentage of homes passed to come in at 82.0%, 85.0% and 88.0% in FY18F, FY19F and FY20F, respectively.
• The increased penetration rates would in turn be underpinned by growth in households (assumed at 2% per annum for FY18F and FY20F), migration of end-users from older technology to fibre and growth in data consumption, in our view. For the non-residential and NBAP segments, we forecast end-user connections revenues to increase at a CAGR of 16.4% and 51.9% from FY17 (pro forma) to FY20F, respectively.
• Although we project EBITDA margins to soften from an estimated 74.8% in FY17 (pro forma) to 69.7% in FY18F, 70.5% in FY19F and 70.0% in FY20F due largely to higher operating expenses which include additional government licensing fee payable to URA and increase in Central Office security manning services, EBITDA growth for FY18, FY19 and FY20 is still forecasted to come in at 2.8%, 5.2% and 5.0%, respectively.
• Correspondingly, we project NLT NBN to deliver distributions to unitholders of S$170.1m in FY18F, S$181.1m in FY19F (+6.5%) and S$185.4m in FY20F (+2.4%).

Exceeded forecasts on cost efficiencies 

• NLT NBN reported strong 3QFY18 (1 Oct 17 – 31 Dec 17) and YTD (19 Jun 17 – 31 Dec 17), as actual results exceeded management forecasts largely due to cost savings and efficiencies. YTD revenue was 0.2% below forecast at S$148.2m due to lower installation revenue but operating expenses came in 5.3% lower than forecast at S$117.8m mainly due to lower operating needs and deferments due to timing reasons but will be incurred in the future. YTD staff costs were also lower as actual average headcount was less than forecasted, coupled with higher capitalisation of labour costs as more projects were completed as compared to forecasts. Consequently, NLT NBN achieved a YTD profit after income tax of S$34.7m, which was 20.6% higher than YTD forecast.
• Operationally, as at 31 Dec 17, NLT NBN’s end-users for residential fibre connections reached 1.17m (30 Sep 17: 1.14m) and remains on track to achieve its target of 1.18m by 31 Mar 18, while end-users for non-residential reached 43,228 (30 Sep 17: 42,028), exceeding its target of 42,800 connections by 31 Mar 18.

Gearing expected to increase, but to remain at comfortable levels 

• NLT NBN had a total debt/EBITDA ratio of 2.3x, as at 31 Mar 2017, on a pro forma basis. 
• Looking ahead, given our belief that NLT NBN will take-on more debt to fund its capital expenditure requirements, we expect its total debt/EBITDA ratio to increase to 3.3x in FY19 before tapering down slightly to 3.1x in FY20. This is still at a healthy level, in our opinion.

PEERS COMPARISON & VALUATION 

We believe NLT NBN operates on a unique business model and hence it has no direct or close comparables. 

• In our view, the business trusts and real estate investment trusts listed on the Singapore Stock Exchange own assets which are of a different nature as NLT NBN and thus we will not be using them in our peers’ comparison.
• We breakdown our selected peers from developed markets in the region (Singapore, Australia, Hong Kong, Japan and New Zealand) into two main categories:
  1. broadband service providers and
  2. regulated utilities players which we believe operate under a regulated asset base (RAB) model.

NLT NBN is in a healthier financial position and offers higher margins as compared to its peers, in our view. 

• Referring to Exhibit above, our selected broadband service provider peers are trading at a median Bloomberg consensus current year distribution yield of 5.9% and a median consensus next year distribution yield of 5.6%. On the other hand, our selected regulated utility peers offer median distribution yields of 5.5% and 5.8% for the current financial year and next financial year, respectively. 
• Overall, the median distribution yield of our peers set is 5.7% for the current financial year and 5.8% for the next financial year, based on Bloomberg consensus estimates. Comparatively, based on 13 Mar 18 closing price of S$0.82, NLT NBN’s forecasted distribution yields are 5.3% (annualized) and 5.7% for the current financial year and next financial year, respectively. 
• We believe the discount on yields for NLT NBN vis-à-vis its peers is justifiable given its resilient business model, dominant position in Singapore within the residential fibre segment, as well as highly defensive income streams.
• Comparing NLT NBN to our chosen peers, we note that NLT NBN’s total debt to EBITDA ratio of 3.1x (estimated end-FY18F figure) is higher than its peers’ market-cap weighted average of 2.9x and the median of 1.6x.
• In terms of profitability margins, NLT NBN’s EBITDA margin compares favourably to its listed peers, coming in at 69.7% (estimated FY18F figure) versus its peers’ median of 32.1%. Even though we expect NLT NBN’s EBITDA margin to stabilize to 70.5% in FY19F and 70.0% in FY20F, this is still significantly higher than its peers.

Valuing NLT NBN using dividend discount model 

• We value NLT NBN using the dividend discount model (DDM) as we expect it to pay out stable free cash flows generated from its assets at regular intervals. DDM is also a commonly used industry metric to value business trusts, real estate investment trusts and yield stocks, in our view. 
• We derive an estimated equity fair value of S$3.54b or S$0.91/unit for NLT NBN after inputting our financial forecasts and capital asset pricing model (CAPM) assumptions (risk-free rate: 2.8%, market risk premium: 6.0%, adjusted beta: 0.691, cost of equity: 6.9%, terminal growth rate: 0.5%) in our model. Based on the 13 Mar 18 closing price of S$0.82, we initiate coverage on NLT NBN with a BUY rating and Fair Value estimate of S$0.91. 
• Amidst all the market volatilities driven by fears including those of interest rate hikes, rising inflation, global trade war and potential slowdown in global economy, we view NLT NBN as a safe haven with a defensive business that provides steady income streams to unitholders.

Eugene Chua CFA OCBC Investment | Joseph Ng OCBC Investment | http://www.iocbc.com/ 2018-03-14

OCBC Investment SGX Stock Analyst Report BUY Initiate BUY 0.91 Same 0.91