IT’S ABOUT EFFICIENCY NOT SCALE, SILLY.

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MHOR HIRES DEUTSCHE’S FORMER HEAD OF RESEARCH DOMINIC ROSE
October 18, 2016
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JAMES SPENCELEY FEATURED IN THE AUSTRALIAN FINANCIAL REVIEW
November 20, 2016

Since leaving Vocus I’ve been inundated with calls from people asking about the future of retail telecommunications and NBN.

With last week’s announcement of MyRepublic, now the 4th such serious challenger brand entering the NBN space, a number of the pieces are coming together.

The conclusion, “It’s about efficiency not scale, silly”. Which is a fitting title for the first of what will be a regular note I’ll write to the MHOR mailing list database.

To answer the question on the future, we need to look at both where we’ve come from and why the industry has done what it’s done.

Fuelling the rally in listed Telco stocks over the last 6-7 years has been consolidation and resulting M&A, leading to a multi year sector wide rerate, underpinned by increasing growth rates, material synergies and incredible cash flow benefits of that M&A activity.

Those effects aside, what was at the heart of that M&A activity, what was the M&A raison d’être?

As always, the macro drives individual events and it was the prospect (and then reality) of the NBN which was the root cause of consolation. The view was, that to survive in retail Telco in the post NBN world you have to have scale and he who has the most scale, would have the most benefit.

You can’t break the laws of physics and Newton’s 3rd law seems apt, that being “for every action, there is an equal and opposite reaction”. The action was consolidation; the reaction was complexity.

The markets have been shifting their thinking towards what is next for the sector (hence the phone calls), who wins and what is the prize.

The question becomes, what are some high probability conclusions?

Given NBN’s pricing model provides no volume discount on the per user price, there is in fact no linear cost benefit to scale. A reseller does however require a minimum amount of scale to operate in an NBN service area but once that scale is reached it can operate with a gross margin not too distant from that of the larger 4 incumbent Telcos.

Given everyone is a reseller, buying on the same terms, irrespective of volume, it appears more about efficiency and nimbleness than scale.

Newton’s third law still applies, scale via acquisition has led to complexity which implies a greater cost to serve. Size, age and incumbency means the larger and older businesses have more overhead and structure which makes them all less efficient than the new entrants.

Incumbency can be a great thing, it’s a blessing when the world tomorrow is the same as it was yesterday. If tomorrow is different, then incumbency shifts from advantage to disadvantage and that is typically when we see disruptive and nimble businesses enter the market (and typically do well).

Human nature is to always assume that what is going on today will continue on forever. As investors we need to continually challenge that basic human nature.

The announcement of 4 very major and very serious new entrants to the NBN reseller market leads me to think that for the first time, the Telco market of tomorrow has the real potential to be different than yesterday.

So let’s look into some of the reasons that might be;

If we look at the 4 incumbents, they have a couple of well known issues

  • Cost To Transfer™. This is the operational cost to transfer a user from legacy ADSL to NBN. This increased cost will impact their short term earnings. The question the incumbent 4 face is whether to delay that impact to earnings or proactively migrate users (active migrations). If a Telco wants to avoid the transfer costs, they face the real risk that one of their competitors (or the new entrants) will do the migration (new activation) for them. The notable exception here is Telstra, who is astonishingly paid to migrate users to NBN. 
  • All 4 face a reduction in margin. The case for not wanting to actively migrate users is not only about avoiding the costs to migrate but more importantly avoiding the negative impact to per subscriber margin of the increased input cost under NBN. Not only are the incumbents (excluding Telstra) having to pay to migrate their users, their reward for this investment is lower margins.

The conclusion we can draw from the above is that 3 of the incumbents will either have no strong desire to actively migrate their users, which leaves the door well ajar for the new entrants or will force them to bring cost and margin reduction forward to attempt to protect the existing user base.

To understand how much tomorrow could change we also need to look at the advantages the 4 new entrants have and conclude how successful or not they can be against the incumbent providers.

What we know for sure is these new entrants don’t have the cost and distraction to migrate their users from ADSL to NBN, they also don’t have margin to lose by connecting users to NBN. The NBN simply represents upside.

These entrants haven’t completed their processes yet, all 4 probably haven’t connected a single user. It’s still too early to see them in market share stats but our job as investors is to think into the future and probability weight what we can see.

Each new entrant has idiosyncratic advantages. So the question is, how effective and what advantage do these guys have?

  • Amaysim: The Amaysim business was founded on a low cost and efficient online operation based on modern (world class) IT systems. They have in fact won awards for the Customer Innovation.

Those leading operational and IT systems allow them to operate a largely self service model providing a very low cost per subscriber by minimise overheads. They are an award winning customer experience organisation which uses technology to enable them to make sizeable company profits from a few dollars of customer margin.

Amaysim have grown to over 1 million mobile customers in only a handful of years. Additionally, they have great distribution, undeniable marketing skills and a loyal, satisfied user base.

The company has indicated they will be primarily targeting cross sell to their existing base, which will give them a low cost to acquire. Given their low cost position in mobile, you would assume the Amaysim customer base has a large overlap with the lower cost operators rather than Telstra/Optus.

  • Vodafone: Of the 4 new entrants, Vodafone has the largest user base of 5.44 million customers (and a much bigger historical database). More importantly, they know where their customer lives (via bills and GPS data) and can market (for zero cost) directly to them via SMS when the client’s building is lit by NBN. They won’t have the “new world” efficiency advantages of Amaysim but their cost to acquire within their own user base would be incredibly low and incredibly effective.

If Vodafone can get their marketing act together (and they are typically pretty good at that), they will make it very easy for their mobile customers to add an NBN service to their account. It is a safe assumption that a Vodafone mobile user is least likely to have a Telstra fixed service and again most likely to have a service from one of the lower cost brands.

  • Foxtel: As the incumbent PayTV operator Foxtel again have a large existing customer base of 2.8 million homes. Importantly they have a powerful (and free) marketing tool at their disposal. If used effectively with a well priced plan they could be an incredible force.

Historically Foxtel hasn’t done an amazing job bundling ADSL with their core PayTV offering. The ADSL add on to an existing PayTV customer was +$100 for a 500GB plan which was not at all competitive.

What establishes that they are serious this time is their new packages and it would appear that Telstra have let Foxtel lose on the market. Their initial NBN offering is a bundle of pay-tv, home phone and unlimited NBN for $111. Obviously more competitive plan that their last broadband entry and at least on the surface demonstrates there is real intent to gain broadband market share.

Overall a Foxtel user is more likely to have a Telstra or Optus fixed service than a discount operator.

  • MyRepublic: The most disruptive entrant to the market, MyRepbulic is the most recently announced entrant to the NBN market and will begin offering services by the end of November.

They are a successful and disruptive telco reseller who started in the Singapore market in 2011 and now have ~5% market share in their home market.

Their recently announced plan is to launch NBN in Australia at the fastest NBN speed available of 100mbps plan at the cheapest price point in the market ($59.95). This compares to the existing discount operators offering 12mbps services for between $59.95 to $64.95. MyRepublic are a modern reseller with strong operational and IT systems, they exist on low margin in their existing markets. They have an over-riding desire to be disruptive on both speed and price (or another way to put it, they don’t seem as concerned about protecting margin as about gaining market share).

If there is one data point to assume the market tomorrow is going to be different from yesterday it is MyRepublic recent announcements.

MyRepublic will compete most directly with the low cost incumbent brands but for the speed at their price point, it will be compelling for all parts of the market.

There is now a material increase in the number of participants in the new (NBN) Telco industry. Companies like MyRepublic are generally more aggressive, they are willing to launch when the density in NBN deployment is only just arriving, you would expect them to be leading that trend and not at the end of that trend.

If (and it’s a big if) MyRepublic can offer the highest speed plan in the market for the lowest price and generate an adequate return, this demonstrates that efficiency of delivery and start up mentality would be a huge advantage over incumbency and infrastructure. If they can make these plans work, then at a minimum there is a large amount of price compression coupled with the well known cost increases for the incumbents.

Now we have to pause, while we’ve talked about the 4 major new entrants to announce their plans, the question is, who could be out there planning to launch? Amazon last month announced they are becoming an ISP in Europe, could they do the same here? Will Netflix or Google do the same at some point ? How much additional competition could come?

As fund managers our job is to look at the macro themes and the NBN is one of the largest capital works projects in Australian history. Who are the winners from the next phase of the Telco journey? What does this mean for investing in the small cap world and specifically the MHOR Australian Small Cap Fund ?

We believe Amaysim (ASX:AYS) represents the best listed option to directly invest in the NBN thematic. The current business as a Mobile Virtual Network Operator (MVNO) has no NBN downside compared to it’s fixed listed Telco peers. The Amaysim business is trading on 14x P/E (vs. a market average closer to 17x) with a more than above average growth rate (EBTIDA expected to grow ~25% to FY17) and a ~5% dividend yield. It’s core business is very, very reasonably priced which implies a free option on NBN upside success. That gets even more interesting given it is entirely possible AYS could earn more in absolute dollar margin per subscriber from NBN than from their MVNO business.

The other winner from NBN we believe is NextDC (ASX:NXT).  With faster speeds and better Internet provided by the NBN roll out, people’s adoption of the cloud will increase. This means services from the likes of Microsoft, Apple, Dropbox and those using Amazon AWS will drive significant expansion in the amount of space required locally by those operators. NextDC as the leading national data centre operator and likely supplier to those names is the likely major beneficiary of that growth. NXT is growing EBTIDA (by our numbers) at 80-85% to FY17. This is a business growing at 2.5-3 times faster the the listed US peers while trading on 1/3rd the price to book. NXT is trading at a significant discount to local private Data Centre transactions, taking the mid point of the most relevant recent transactions based on CY17 there is 35-50% to the current share price before you factor in S2,M2 and B2 expansion.

We are at the early stages of the growth cycle of cloud adoption and faster, better and cheaper residential broadband will only drive demand from cloud providers for NextDC’s assets. NextDC is the only pure way to play the cloud thematic and the increase in speed and take up rate of NBN will only increase the pace of the Cloud’s uptake across the country.

 

MHOR_Asset_Management_James_Spenceley

James Spenceley

CEO, MHOR Asset Management

James Spenceley does not personally own shares in any listed Telco but does own NextDC. The MHOR Australian Small Cap Fund owns shares in both Amaysim and NextDC. Standard disclaimers apply, this memo and commentary is not Investment Advise.

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