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Morningstar | NTT’s 1Q Result Slightly Below Expectations but Firm Will Continue to Take Costs Out. See Updated Analyst Note from 07 Aug 2018

On an underlying basis, narrow-moat Nippon Telegraph and Telephone Corp's, or NTT’s, first-quarter fiscal 2018 (quarter ended June 2018) result was slightly below our expectations, and after small adjustments to our forecasts, we retain our fair value estimate at JPY 5,600 per share. Our fair value estimate implies a forward price/earnings multiple of 12.5 times, and the stock looks slightly undervalued at this price. We expect shareholders in the stock would be holding for the dividend, which will increase this year, and we forecast steady dividend growth over the five-year forecast period, underpinned by continued cost reductions, with plenty of scope still likely to be available from this. We rate NTT as a narrow-moat company, despite the fact that its return on invested capital, or ROIC, has historically been below its weighted average cost of capital, or WACC. Given the improved earnings both organically and from 67%-owned NTT DoCoMo, NTT’s ROIC rose above WACC in fiscal 2016, and we forecast it to remain there throughout our forecast period. As an incumbent telecom operator, NTT benefits from an efficient scale moat source, with much of its fixed-line network highly unlikely to be overbuilt and little likelihood of successful new entry into the three-player mobile market, despite Rakuten planning to enter the market in 2019.

NTT DoCoMo, which reported a week ago, accounted for over 100% of the business's operating profit growth, with operating profit excluding NTT DoCoMo declining by 6.2%. Regional communications and long-distance and international communications both saw operating profit declines of around JPY 9 billion, with data communications reporting slight growth. Management alluded to some maintenance costs having been brought forward this quarter without quantifying the impact.

NTT continues to benefit from the move to the Hikari Collaboration Model whereby resellers take over the sales and marketing expense for wholesaled broadband lines. Of its 20.7 million total fibre broadband connections, 11.6 million are now via wholesale, with 500,000 wholesale broadband customers added over the quarter. At this rate, NTT’s Hikari Collaboration cost savings will likely diminish in around two years, after which we forecast flatter margins. The company now has over 700 broadband resellers, including companies in telecoms, energy, real estate, and security.

Management is forecasting flat capital expenditure in fiscal 2018 at JPY 1.7 trillion. We forecast broadly flat capital expenditure over the next five years, with assumed lowering expenditures on fixed line being offset by 5G expenditure in the NTT DoCoMo mobile business. Management is forecasting a 13% increase in dividend in fiscal 2018 to JPY 170 per share from JPY 150 per share. This dividend puts the stock on a dividend yield of 3.2%, which is quite respectable in a low-yield Japanese environment with 10-year government bond yields near zero.

NTT’s largest business is its 66% stake in mobile operator NTT DoCoMo, whose first-quarter 2018 (quarter ended June) result was slightly above our expectations, putting the company in a good position to achieve or beat its own full-year guidance. First-quarter operating profit was up 9.9%, while telecom services revenue was up 2.5% and mobile services revenue increased by 0.3%. NTT DoCoMo management plans to ramp up its cost reduction program in fiscal 2018, lifting targeted cost reductions to JPY 120 billion from JPY 90 billion in fiscal 2017, and JPY 34 billion was achieved in the first quarter, so it is on track for this full-year target. The company is changing accounting standards from USGAAP to IFRS in fiscal 2019.

Rakuten's plans to build out a mobile network in Japan, which would launch in October 2019, is notable for NTT DoCoMo, and therefore NTT. The business targets at least 10 million customers by 2028. At its result briefing on Aug. 6, Rakuten indicated that it expected to spend JPY 526.3 billion in total capital expenditure over the 10 years from 2018 to 2028, targeting 10 million customers by year-end fiscal 2028. Rakuten’s spend and network ambitions seem tiny compared with NTT DoCoMo, which carries property, plant and equipment of JPY 9.8 trillion-plus, with annual capital expenditure of JPY 500 billion-JPY 600 billion. It is difficult to see how Rakuten’s network can be competitive with the existing operators with this planned expenditure, so we see a lower price as the main potential attraction. Rakuten has been allocated a 1.7 Ghz spectrum license, and we expect it will launch a network, but at this stage we are far less confident that it will build a sustainable fourth-operator business. Nevertheless, it could cause a price war while it attempts to build its customer base.