Sustainable returns from Telco sector

Sustainable returns from Telco sector

Telecommunication companies (Telcos) have been central to many of our activities during the COVID-19 crisis, ranging from virtual wine tasting nights with friends, working from home, Netflix binges or simply ringing family.

In recent years Telco’s have been challenging for investors with falling margins from mobiles and the NBN crushing broadband margins.  The worst of this may be behind the sector now and investors are now presented with an investment opportunity that may be COVID-19 proof.

An investment into a Telco company typically involves two main segments, infrastructure and retail/business operations which includes broadband, mobiles and services. .  

In Australia the three major players are Telstra, Optus and TPG which recently merged with Vodafone.  Telstra and TPG are listed on the ASX.

According to Andrew Peros (Deputy Head of Research, Ausbil) “infrastructure is probably the most attractive on the assumption that it can be successfully separated from the retail assets.  Telecommunications infrastructure provides a long term steady cash flow which is highly valued by the market.  Unfortunately, in Australia, there are no pure play communication tower investments.  Telstra’s communications infrastructure are currently part of the overall business and have not yet been demerged as a separate business, similarly with TPG’s cable infrastructure”

That may be about to change following a restructure announced last year which resulted in Telstra splitting its infrastructure assets into a separate business segment called InfraCo.  InfraCo consists of exchanges, ducts, data centres, subsea cables, fibre and 8,000 towers that host networking equipment.

Towers and other parts of InfraCo currently generate revenue from servicing Telstra alone.  If this division were separated from Telstra, these assets could increase revenue by servicing other Telcos.  A tower that currently services only Telstra could service all three mobile networks.  Competitors would have to supply their own networking gear, but the infrastructure owner could earn three times as much revenue. Mobile network towers are a natural monopoly and it makes little sense to duplicate a network once it has been constructed.  We don’t duplicate water pipes or electricity wires and the same can apply to mobile towers. This is an important opportunity for investors to grasp.

Annabel Riggs (Telco Analyst, Airlie Funds Management) is “attracted to the mobiles market, with the sector transitioning into a more rational pricing environment after a period of intense competition between network operators.  We are beginning to see evidence of a more rational market with Telstra lifting prices a couple of weeks ago across its post paid mobile plans.  This is positive for earnings and returns.”

5G is the next battle ground for the Telco’s.  Riggs believes that “network operators will selectively compete with the NBN in some areas by using a fixed wireless product.  The margins and returns on this product work if the customers are relatively low usage.  We have seen in New Zealand that about 20% of their broadband base is now on Fixed Wireless and bypassing their own version of the NBN.”

Peros adds “telcos are likely to hesitate on fixed wireless if competition between operators is expected to lower returns on capital, and there is a risk in Government support firming to protect the value of the NBN.”

Government regulation would seem one of the key risks to investing in the Telco sector.  The relatively high access costs the NBN charges the telco resellers for broadband is a good example.  Riggs points out that the NBN has improved its pricing model however the total cost of accessing the NBN for telcos is still much higher than the copper network.  The higher access costs to the NBN has put huge pressure on earnings of the telco sector.

The decision to ban Huawei from providing 5G equipment in Australia was another big decision.  Huawei was a lower cost equipment provider which will ultimately increase expenditure for TPG which was planning their 5G build around Huawei equipment.

Peros flags the economies of scale in a geographically large country with a small population as another important risk.  

Investors should also pay attention to some interesting new entrants.  Riggs points to Uniti Group who has recently acquired Opticom as having an interesting opportunity to challenge the large players in the fibre market.  Peros likes NextDC which owns data centres which will benefit from the increased demand for data now that a greater proportion of the workforce are working from home.

It would seem that Telco’s revenues are largely COVID-19 proof, but the growth story could come from the demerging of infrastructure and new entrants.

This article was published in the Australian Financial Review online on Monday 3rd August 2020

Note:  Mark Draper, Shannon Corcoran and their entities own shares in TPG and Telstra.