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Sunday 1 September 2013

Safe Harbours in Stormy Weather

The mere talk of taking the punch bowl away from the financial markets have caused convulsions in emerging markets.  Syria gassing its own people did not help.  The US military industrial complex have mobilized their propaganda machine in response to the apparent "red-line" that was crossed by Assad (no concrete proof he did it - yet).  Does not matter, the Assad regime must go. 

How convenient, the US debt ceiling will be breached in less than two months and this is just the excuse needed to raise the debt ceiling to pay for the missiles manufactured by Raytheon

Where US and its western allies go, trouble follows shortly.  Iraq and Libya, both oil rich nations are now laid to waste.  Incidentally Syria also produces oil, not a lot, for those who do not know.  But in this instance it is not about oil in the ground but rather the gas pipelines running from Iran-Iraq-Syria and eventually connecting to Europe.  The Qataris want to do the same but they are not on friendly terms with Syria.

The US has already made up its mind, the back pedaling to congress with behind the scene lobbying will eventually build consensus to give the invasion legitimacy. 

It is not if, but when, US will lay siege to Syria.

I don't slavishly follow markets, but lately thanks to unintended consequences of central banks' meddling when they should not and the threat of another Middle East war, I am thinking better safe than be sorry.

Defensive utility stocks and social considerations

I generally try to avoid water and energy companies, particularly in Asian markets.  The reason has nothing to do with investment merits but rather social.  I believe people should have access to clean water and energy at a reasonable cost, even to the point of it being subsidized.  After all, corporates defile the environment and leave the clean up costs to taxpayers. 

In the UK, since privatization, water and energy bills have risen way faster than inflation.  And this have thrown many people into fuel poverty.  People are making choices between heating the home or feeding the kids.  Older people die from not being able to heat their homes properly in the winter.  Despite this, huge profits are made by utility companies.  Increasing dividends and rising share price have certainly benefitted shareholders and management award themselves even larger bonuses.  I cannot resolve the dichotomy: Bad for the conscience; Good for the wallet.

Water and power generation companies in Asia still require heavy investments to improve water quality and construct more efficient plants.  Unlike in the West, these strategic assets remains majority owned by the government.  This means at any point social agenda can override profit motive.

Telecom operators are different, apart from government gouging operators for spectrum and now the occasional snooping, they largely leave Telcos to the fate of the free markets.  This makes it more palatable for me.

Is there any good value Telcos out there?

I have been playing Hay Day and Clash of Clans since May 2013.  Both games are developed by Supercell, a US based games developer.  It is extremely addictive; when you need to feed your chickens, milk the cows and sell fresh produce or upgrade your defenses or lay siege to your enemies you just have to have your wireless devices with you all the time.

If you are not an insider, gaming companies are impossible to analyze.  Mostly stock prices already trade at sky high multiples when it gets the attention of the general investing public.  Instead of looking for the next big game company my attention turned to the telecom sector.  So for the last two weeks I have been busy trying to get up to speed with the telecommunications industry as my understanding of it dates back to the days of Alexander Graham Bell.

Hong Kong telecoms industry is super competitive

With a population of just under 7.2m and five telecommunications service providers, HK is one of, if not, the most competitive telco market in the world.  Little wonder, fighting over a slice of a small cake have driven service providers to be at their best.  HK currently ranks number one in the world for internet speed.  HK boast super fast internet connection 3 times faster than the global average.  The companies that compete in this space undoubtedly have to have huge financial power to compete in the global internet speed race.  These companies are subsidiaries of HK's largest companies:
  • PCCW owned HKT (fixed line and mobile)
  • Australian Telstra owned CSL (mobile)
  • Hutchison Whampoa owned Hutchison Global (fixed line long distance carrier and mobile) 
  • Sun Hung Kai owned SmarTone (mobile)
  • China Mobile
Below are some statistics from OFCA, the industry's regulator.
  • Mobile data usage 7.6 billion Mbs in 2012, it was 638 million Mbs in 2009 (3 year CAGR 129%)
  • Mobile subscriber penetration rate is 231% (one of the highest in the world)
  • 2.40m households, customers with home broadband at 2.25m, 94% penetration rate
  • 2.5G and 3G/4G mobile subscribers 11m
  • Public Wi-Fi access points 19,554


HK Telcos all fired up by Vodafone's sale of its Verizon Wireless stake

On Friday, 30 August 2013, Vodafone announced that is was selling its 45% stake in Verizon Wireless to Verizon Communications for $130bn perked up HK Telco's stock prices. 

SmarTone, the smallest of the five, largely tipped as a target jumped 4.66%.  HKT the market leader fell slightly possibly being viewed as the potential acquirer and Hutchison jumped 4.35% because it has to deal with one less competitor.

SmarTone underperformed its peers for the past two years

I have included Singapore's Sing Tel, StarHub and M1 for completeness given the similarities of the two island states.  It is unclear the reason for the underperformance of SmarTone.  It may have something to do with the negative publicity surrounding its parent, Sung Hung Kai and the Kwok brothers implicated in a corruption involving land deals. 

Business models of HK Telcos

PCCW-HKT is the market leader for fixed line/broadband with 63% market share of residential business and 12% of the mobile market.  Its dominance of the local fixed line market have not really been dented over the years.

Hutchison's owns an extensive fibre-optic network in HK and has a portfolio of submarine and terrestrial cable systems linking HK throughout the world.  Half of fixed line business is carrier services.  It has 28% share of the mobile market trading under the brand 3. 

SmarTone is a pure wireless provider.  SmarTone operates at the premium end of the market with 23% of the postpaid market share.  Based on a Credit Suisse report, SmarTone has the best network.

CSL is also a pure play wireless provider.  It reported revenues of HK$8.1bn and EBITDA of HK$2.1bn giving it a market share similar to SmarTone.  CSL's brands are 1010, One2free and New World Mobility.

Despite the intense price competition and huge investment outlays, market shares of each player have remain broadly stable which just goes to show how sticky the customer is once acquired.  Churn rates remains less than 2% overall.  All operators attempt to increase revenue and profit pool through better customer / service segmentation such as tiered plans and handset tie-ins.  All network operators have reported increased ARPU.  I suspect, it is the significant rise in data usage in the last few years rather than any clever marketing programs that have mostly contributed to increased ARPU.

Not an easy business

The huge cash flows operators make have not gone unnoticed by governments throughout the world.  Since the early 2000s when the UK government started the trend of auctioning spectrums, operators now have to pony up just to ensure they can stay in the game.

The pace of technological change from 2G, 2.5G, 3G and now 4G requires constant investment.  Even when no new technology is introduced, investments in maintaining network infrastructure is not cheap.  For example, over the past ten years, SmarTone spent on average HK$1.1bn or a quarter of revenues on PPE, licence fees and handset subsidies.  HKT and Hutchison spent HK$2.8bn (19% of average five year revenues) and HK$1.5bn (13% of average five year revenues) respectively over the period.

Consumer protection laws have made it easier for customers to change operators and made it easier for new entrants.  Global roaming charges have also fallen.  The constant roll out of new smartphones is both a blessing and a pain.  Subsidizing handsets to acquire new customers can be a drain on cash but conversely customers are tied into longer plans giving stability in revenue streams. 

Financial performance

SmarTone's last financial performance was relatively better than HKT and Hutchison. The 50% increase in revenues is mainly from 100% increase in handset sales and 24% in service revenues.  The combination of higher net margin, asset turnover and leverage results in higher ROE.

All three companies have decent cash flow generating abilities, with operating cash flows well above net income. 

SmarTone debt to EBITDA of 0.5X is the lowest amongst the three operators.  This reflects the recently issued US$200m guaranteed notes.  As the HK$ is tied to the US$, there is no danger of foreign currency risk.  I think it is quite smart of SmarTone to issue debt to lock in on rising interest rates.  The annual charges are well covered by operating cash flows so does not post a risk to the business.  Both HKT and Hutchison carry significantly higher debt loads.


HKT trades at a higher multiple reflecting its near monopoly of the residential fixed line business and cash generating ability.  On a PBV basis, HKT is carrying significant amounts of goodwill which is more than the reserves.   
SmarTone lower PE I suspect is because its FY2013 revenues are expected to be lower than FY2012.  Its PBV is a bit on the high side but not much more. SmarTone's share price is underpinned by a 100% dividend payout ratio. 
From a valuation standpoint, I believe Hutchison offers better value providing a decent dividend yield and a lower PBV (ex goodwill).  Its business is also better diversified compared to SmarTone and its income profile is much more stable overall compared to SmarTone.   

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