EUR 850.00 For Business Accounts Only

Morningstar | Solid 1Q, Full-Year Guidance Unchanged for KDDI; Potential Rakuten Entry the Overhang

KDDI's first-quarter fiscal 2018 result (quarter-ending June 2019) was broadly in line with our estimates with revenue increasing by 1.9% and operating income by 2.6%.  Management's fiscal 2018 guidance for operating income growth of 5.9% and dividend growth of 11% to JPY 100 per share remains unchanged. We leave our fair value estimate of JPY 3,700 per share and USD 17 per ADR. At our fair value, KDDI would trade on a price/earnings ratio of 14.7 times with a 2.7% dividend yield. We believe the Japanese telecom market is a solid three-player market with manageable competition levels, but will likely be challenged by Rakuten's planned entry as a network operator in 2019 and by any impact that SoftBank's domestic telecom IPO may have on its recently benign competitive stance. At this stage, Rakuten looks likely to go ahead with its planned network build and we can expect an incremental increase in price competition in the Japanese mobile market, at least while Rakuten stays in the market. Our KDDI valuation incorporates only an average operating income growth of 3% per year over the next five years, well below the 14% per year growth delivered over the past three years as we expect top line growth to slow and many of the easier cost cuts have already been made. However, a Rakuten entry could send KDDI earnings into decline for a period. We retain our narrow moat rating based on cost advantage and efficient scale. KDDI's shares are trading below our fair value estimate making it an attractive 4-star stock, especially with Japanese 10-year Government bonds yielding around 0.1%.

KDDI's telecom operating income declined by 1.1%, but this was offset by growth from value added (3.9%), business (12%), and global (97%) revenue. Mobile revenue fell 2.5% due to the impact of the new price plans. However, mobile churn fell to 0.71% per month from an already quite low 0.91% in the similar period last year, which is being helped by the lock-in effect of KDDI bundling other services. This is part of KDDI's strategy to branch out from its traditional telecom business moving into what it calls "Life Design." This includes commerce, finance entertainment, education, and energy. It plans to drastically expand its customer touchpoints to many more aspects in life. Of course, many of the initiatives that it is undertaking here are also being attempted by its telecom competitors, and indeed, by its upcoming competitor, Rakuten itself. It is difficult to forecast how successful this strategy will be. Currently, the value-added services segment contributes around 10%-12% of operating profit with that operating income growing at only 3% over the previous full year and 3.9% this quarter so it may take some time before it becomes too meaningful, but it is useful for churn reduction.

The key concern for the Japanese telecom market is that new competition is coming. In mid-December 2017, Rakuten also announced plans to raise debt of a maximum of JPY 200 billion to build out a mobile network in Japan which would launch in October 2019. At its first quarter result briefing in May 2018, Rakuten indicated that it expected to spend JPY 526.3 billion in total capital expenditures over the 10 years from 2018 to 2028, targeting 10 million customers by end of fiscal 2028. Rakuten's spend compares with KDDI which carries property, plant and equipment of JPY 2.4 trillion plus with annual capital expenditure of JPY 500 billion to JPY 600 billion. It is difficult to see how Rakuten's network can be competitive with the existing operators with this expenditure, so we see a lower price as the main potential attraction. Rakuten has been allocated a 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.