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Morningstar | TPG Telecom's Stand-Alone Fundamentals Unchanged; Market Assuming TPG Won't Stand Alone

The 1% lift in TPG Telecom's fiscal 2018 normalised EBITDA to AUD 841 million was in line with management's guidance provided less than three weeks ago, with key performance indicators broadly in line with our expectations. Management's operating prowess was again evident, as the AUD 61 million fall in aggregate NBN-inflicted earnings and AUD 5 million in higher electricity costs were more than offset by continuing efficiency gains and a 6% rise in the corporate division's EBITDA to AUD 330 million.

The underlying fundamentals are such that our AUD 6.10 fair value estimate for TPG as a stand-alone entity is intact. However, shares in the narrow-moat group are trading at a material premium to our intrinsic assessment. The market is not only assuming that the proposed TPG-Vodafone merger will complete, but is baking in significant synergies. If the combined TPG-Vodafone EBITDA of AUD 1.9 billion is capitalised at the current global telecom average EBITDA multiple of 7.6 times, less AUD 4.0 billion in aggregate net debt, we calculate that the current TPG stock price incorporates around AUD 790 million in synergies from the merger. This is not impossible but is easier done on a spreadsheet than in real life, especially as it represents over 30% of Vodafone's current cost base. Furthermore, there are still hurdles to clear for the deal, not the least of which is approval from the competition watchdog.

The strategic rationale for pursuing the Vodafone merger cannot be faulted. TPG is facing its first year of EBITDA decline in fiscal 2019, after a decade of consecutive earnings growth. Its key consumer broadband unit is beginning to bear the full brunt of NBN's margin-crunching economics and there is a limit to extracting operating efficiencies within TPG. This is why management decided to secure its future by becoming the fourth mobile network operator--an audacious strategy so high on execution risks that it appears to have led TPG into the arms of Vodafone.

Management is guiding to fiscal 2019 EBITDA guidance of AUD 800 million-AUD 820 million. This is down 2%-5% from fiscal 2018, breaking a 10-year record of consecutive growth. This is before factoring in any initial losses from the new mobile network operations in Australia and Singapore, which we currently forecast to amount to AUD 32 million combined in fiscal 2019, and is the reason for our AUD 794 million EBITDA forecast in fiscal 2019. All this could become academic, however, if the Vodafone merger completes, as it is likely to lead to wholesale changes to TPG's rollout strategy in Australia, leveraging off Vodafone's existing mobile network.

As for the fundamental shift in TPG's profitability in the consumer division (over 60% of group earnings) and the reason for the expected EBITDA decline in fiscal 2019, National Broadband Network, or NBN, is the key culprit. Before the NBN rollout, TPG enjoyed EBITDA margin of over 40% in the consumer division, thanks to juicy margins from customers on its own ADSL network. Fast-forward to fiscal 2018, and around 45% of TPG's broadband subscribers has migrated to the NBN, which charges TPG as a reseller for access to the government-owned network, resulting in TPG's consumer division EBITDA margin crashing to 29%. It is little wonder that management wants to reduce this dependence on the NBN and harvest the high margins of having customers on its own network infrastructure. This is the whole rationale for TPG rolling out fibre to the basement, or FTTB, and why it decided to become the fourth mobile network operator in Australia (and Singapore), a high-risk strategy that has kick-started consolidation before TPG had a chance to disrupt the market.

In terms of TPG's fiscal 2018 bottom line, normalised net profit after tax before amortisation of acquired intangibles, or NPATA, rose 4% to AUD 433 million. The board declared a final DPS of AUD 0.02, fully franked, bringing the full-year amount to AUD 0.04. The group ended the year with net debt of AUD 1.3 billion, equating to net debt/EBITDA of 1.5 times.