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Morningstar | KDDI Moat Trend Reduced to Negative on Pricing Pressure from Rakuten and Government. See Updated Analyst Note from 05 Dec 2018

We retain KDDI’s narrow moat based on efficient scale but reduce KDDI’s moat trend to negative. We expect some pricing pressure in the foreseeable future, with Rakuten entering the key mobile market and the Government also pushing for price decreases. We retain our fair value estimate of JPY 3,400 and USD 15 per ADR, which was lowered after the second quarter fiscal result in response to the announced price reductions from its competitor, NTT DoCoMo. At our new fair value, KDDI would trade on a price/earnings ratio of 13.4 times with a 3.0% dividend yield.

In August 2018, Chief Cabinet Secretary Yoshihide Suga was widely quoted as suggesting that competition was not working and that Japan's mobile carriers could lower fees by around 40%. At its result at the end of October 2018, NTT DoCoMo dropped a bombshell in announcing as part of its mid-term plan that it would be lowering its prices in the quarter-ending June 2019 to return up to JPY 400 billion (around 10% of its revenue) to customers so that its profits would decline and would not recover to current levels until fiscal 2023 (fiscal year ending in March 2024).

Understandably, this announcement immediately hit the share prices of all three Japanese telecom companies. If the largest telecom operator in the market talks about dropping its prices by 20-40% for low end customers and reducing its overall revenue by around 10% then it is likely to impact on the other operators. However, at their respective results over the following days both KDDI and SoftBank reiterated their targets to keep growing profits and NTT DoCoMo’s parent company, NTT, which earns around two-thirds of its profits from its stake in NTT DoCoMo also indicated that it expected continued profit growth, casting some doubt on the extent to which NTT DoCoMo will really drop price. We suspect an element of regulatory signaling in the announcement.

In mid-December 2017 Rakuten announced plans to raise debt to a maximum of JPY 200 billion to buildout a mobile network in Japan which will launch in October 2019 with peak debt funding planned to reach JPY 600 billion by 2025 before the mobile business becomes free cash flow positive and can begin to paydown the debt. The business targets at least 10 million customers by the end of fiscal 2028. In late April Rakuten was given 20MHz of paired spectrum at 1.7 GHz and has chosen its network vendors. Its planned cumulative capital investment for the period from 2018 to 2028 is JPY 526 billion and it plans to have 96% population coverage by 2025. In October 2018 it announced a cooperation agreement with KDDI which would see KDDI provide it with roaming in Japan in areas covered by KDDI but not covered by Rakuten. This is an important agreement as it will allow Rakuten to be competitive on coverage from launch.

Given its proposed capital expenditure we are far less confident that it will build a sustainable fourth operator business. NTT DoCoMo, KDDI and SoftBank have PP&E and intangibles (ex-goodwill) of JPY 3.2 trillion, 3.4 trillion and JPY 2.7 trillion, respectively, meaning each operator already has assets over five times the planned capital expenditure of Rakuten over the next 10 years. It’s hard to see Rakuten’s planned capital expenditure allowing it to build the scale required for a sustainable telecom business. Given this capital expenditure it is also hard to see how it could sustain very low prices for long as the network would likely run into capacity issues, although we may see some short-term pricing pressure. Interesting research from research.rewheel.fi which showed that the median gigabit price for 3-player telecom markets on average is 81% higher than those for 4-player markets with a total of 41 countries in the survey. This does not mean that we expect and 81% price cut from Rakuten's entry but shows that four-player markets tend to much more competitive than three-player markets.

We believe the impact of a new entrant is largely a function of how much money it is willing, and able to spend to enter the market. Rakuten currently earns an operating profit of around JPY 150 billion per year, less than 20% of the average operating profit generated by the incumbent telcos. Its current enterprise value is also less than 20% of the existing telcos. We also note that Rakuten’s core e-commerce business faces intense pressure mainly from Amazon and Yahoo Japan, with each company now having similar market share after Amazon has taken market share over the past few years. We believe its small size and pressure on existing business will limit how much extra capital Rakuten could put into the telecom business to increase its impact on the market.