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Morningstar | Spark Responds to Competitive and Structural Pressures with Agility

We lift our fair value estimate on Spark New Zealand 3% to NZD 3.80 (AUD 3.65 at current exchange rate), mainly reflecting higher than previously expected cost-saving retention from the Quantum program. Indeed, the transformation and Agile initiatives (NZD 26 million in labour savings) single-handedly drove the 4% lift in fiscal 2019 first-half underlying EBITDAI to NZD 489 million, an increase that other legacy telecom operators would drool over.

This is just as well, as competitive intensity remains elevated across the board. Spark is fighting hard, as evidenced by the 3% rise in higher-value post-paid mobile customers in the first half and the 11% growth in wireless broadband customers. However, market reality is such that management has cut its fiscal 2019 growth target for mobile service revenue to 3% (from 5%), cloud, security and service management revenue to 10% (from 15%), while overall broadband connections are declining (down 2,000 in the half). Add to this the continuing heavy impact of falling legacy voice revenue, management should be commended for taking decisive action on implementing the all-encompassing efficiency drive--one that has yielded annualised benefits of NZD 110 million.

Our greater comfort in retention of some these benefits has led to a 2% to 3% lift in our near-term operating earnings estimates. This resulted in the revised NZD 3.80 fair value estimate, with shares in the narrow-moat-rated group now trading broadly in line with this intrinsic assessment. The key longer-term question is how much of the Quantum benefits will eventually be eaten away by market competitive dynamics and the falling but still sizable NZD 500 million legacy voice revenue base (with margin of close to 50%). We remain conservative on this front, as reflected in our five-year CAGR forecast for EBITDAI of 2.5%, with EBITDAI margin easing from forecast 30.3% in fiscal 2019 to 28.9% in fiscal 2023.

A wild card to the long-term margin picture is wireless broadband. A new lease of life appears to have been injected on this front, with Spark lifting such customers by 11% in the half to 129,000, aided by the launch of the "Unplan" product. This resulted in another NZD 8 million saving on input access costs, and the wireless broadband base now would spare Spark around NZD 62 million a year in such input access costs going forward. We understand management's reluctance to talk up this wireless inroad, having missed the 125,000 target in fiscal 2018. However, every customer it can acquire on its wireless infrastructure and away from third-party fibre is good for profitability. And the fact Spark already has 18% of its broadband subscribers on wireless on 4G and 4.5G must give Spark significant hope as to what it can do with 5G on boosting wireless broadband uptake. It is little wonder that management is chomping at the bit for the government to allocate 5G spectrum, so that Spark can expedite the next generation mobile network.

In terms of result details, Spark has adopted various new IFRS accounting standards and treatment of investment income (mostly dividends from Southern Cross Cables). This has resulted in a new operating measure called earnings before interest, tax, depreciation, amortisation and investment income, or EBITDAI. On that metric, Spark reported EBITDAI growth of 7% to NZD 489 million, or up 4% adjusted for Quantum implementation costs in the prior period. NPAT fell 6% to NZD 153 million, or 11% on an adjusted basis, due to the absence of any dividend from Southern Cross Cables (versus NZD 27 million in the prior period) and higher depreciation as a result of the IFRS 16 adoption on leases. Management reiterated guidance across the board for fiscal 2019 under the new disclosure regime, with EBITDAI range of NZD 1,065 to NZD 1,095 million in line with our forecast of NZD 1,085 million.

The board declared an interim dividend of NZD 0.125 per share, 75% imputed. First-half underlying free cash flow (as defined by management) grew 33% to NZD 146 million. However, including working capital movements and the absence of Southern Cross Cables dividends in the half, free cash flow fell 33% to NZD 108 million. Balance sheet remains comfortable, with net debt/EBITDAI at 1.2 times which is well under the group's upper limit of 1.4.