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Morningstar | NTT’s 2Q in Line but Medium-Term Guidance Looks Aggressive

On an underlying basis, narrow-moat Nippon Telegraph and Telephone Corp's, or NTT’s, second-quarter fiscal 2018 (quarter-ending September 2018) result was in line with our expectations but we lower our fair value estimate to JPY 5,400 from JPY 5,600 per share on the back of subsidiary NTT DoCoMo’s medium-term plan which will see its operating profit lower in fiscal 2019 and only recover in fiscal 2023. Our fair value estimate implies a forward price/earnings multiple of 11.7 times and the stock looks undervalued at this price. We expect shareholders in the stock would be holding for the dividend which will increase this year and we forecast slow, but steady dividend growth over the five-year forecast period underpinned by continued cost reductions. We rate NTT as a narrow moat company, despite its return on invested capital, or ROIC, having historically been below its weighted average cost of capital, or WACC. Given the improved earnings both organically and from 67%-owned NTT DoCoMo, we note 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 presented its medium-term plan which would see it growing EPS from to JPY 640 by fiscal 2023 from JPY 425 underlying in fiscal 2017. This would be helped by JPY 800 billion in cost reductions and strong growth in overseas sales and operating margin. Given NTT DoCoMo, which contributes around two thirds of NTT’s profits, is targeting to only return operating profits to fiscal 2017 levels by fiscal 2023, we see NTT’s target as a big stretch. We forecast EPS to grow to JPY 516 by fiscal 2022, which is the outer year of our specific forecasts so we are below management’s forecast.

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. Twelve million of its 20.9 million total fibre broadband connections are now via wholesale with 376,000 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, although 90% of its wholesale customers connect via NTT DoCoMo and SoftBank.

NTT’s largest business is its 66% stake in mobile operator, NTT DoCoMo, whose second-quarter 2018 (quarter-ending September 2018) result was slightly above our expectations but whose guidance sent the NTT DoCoMo stock plummeting. Its medium-term plan involves a review of mobile rate plans that will return up to JPY 400 billion to customers and see operating profit decline with a target of recovering operating profit to current levels by fiscal 2023 was a negative shock to us. The concern for us with this medium-term plan is how much influence the Government has on NTT DoCoMo’s pricing plans and future returns. Government comments about how much Japanese customers pay for mobile service made in August 2018 seem to have hit the mark. Previous comments from Government along the same lines in 2015 and 2016 did provoke a response from the operators, but the newly offered rate plans were not as generous as these appear to be and did not have such a negative impact on profits as foreshadowed by NTT DoCoMo management. Management also indicated that the entry of Rakuten into the market in 2019 was also an influence over the planned rate cut decision. To the extent they will make it more difficult for Rakuten to attract customers, then this may not be such a bad thing for the industry in the longer term. Given these plans are targeted at reducing pressure from the government, we expect NTT DoCoMo has an incentive to maximize the forecast negative impact on the company, hence the forecast of “up to JPY 400 billion” to be returned to customers. We expect the actual impact will likely be smaller.

In terms of forecast impact, we have no details on the new low-cost plans to be announced and launched in first-quarter fiscal 2019 (quarter-ending June 2019) and whether they will automatically apply to existing customers or whether they will apply as customers come off existing contracts. We assume the forecast customer returns will be spread across two years. We also expect NTT DoCoMo to continue with its underlying cost-cutting which has been running at over JPY 100 billion per year so this should be able to absorb some of the impact. Indeed, some of NTT’s JPY 800 billion cost reduction (likely 50%-70% in our view) will be attributed to NTT DoCoMo. However, we also recognize that NTT DoCoMo will be spending on 5G and associated new service development given its plans to have a precommercial 5G service launched from September 2019 in time for the Rugby World Cup with a commercial 5G service launch in Spring 2020. The outcome is our forecast of NTT DoCoMo’s operating profit on a stand-alone basis to fall to the mid JPY 800 billions for three years from fiscal 2019 to fiscal 2021, a reduction of around 19% for fiscal 2020 and 2021, before recovering towards to the JPY 990 billion target by fiscal 2023.