Stocks of the month – Telstra and TPG – April 2023

Daniel Moore and Lucas Goode discuss the Telco sector, its history and how it’s positioned for the future along with some analysis of Telstra and TPG, which are holdings in IML’s large cap and small cap funds as well as listed investment company QVE.

Edited transcript

Daniel: Hi, everyone. We’re here to talk about stock of the month today, and with me, I’ve got Lucas Goode, our telco analyst for our large and small cap funds. And it’s quite an opportune time, I guess, to talk with you because today, we’re going to talk about not just one stock, but two. We’re going to talk about Telstra in our large cap funds, why we own it. And TPG in our small cap funds. So, Lucas, why are we so positive about the telco sector at the moment?

Lucas: So to kick things off. I guess, first, let’s start by saying that telecommunications companies tick a lot of the boxes that we at IML look for in our investments. They are the original recurring earnings businesses in some ways. It’s highly nondiscretionary, I mean, in the hierarchy of needs, your monthly phone bill probably sits only below rent and shelter in the hierarchy of needs. It’s a heavily concentrated industry, there are only three full service operators in the country. And also, you’ve got an industry that’s going through a period of significant market repair and the other thing as well, in that, you know, you do look for some long term growth. Well, the population is usually growing and that means that the number of telco services is usually growing as well. Didn’t quite work that way during COVID, but we’re coming out of that now. But I think the market repair is the key point that we wanted to touch upon today and why we think that right now TPG and Telstra both make good investments. And I know Dan, it’s something you spend a lot of time looking at with your Telstra position.

Daniel: Yeah. I think it’s fair to say the telco industry went through a pretty extreme price war, probably starting around 2016, 2017, and we saw prices across the whole industry fall for several years in a row. And it was pretty devastating, I guess, for industry returns, and we saw industry returns get to around 1% or 2%, which is just well below their cost of capital for the industry. And that led to some consolidation and we saw in around 2020, we saw the merger of TPG and and Vodafone.

Lucas: Agreed in 2018, actually. But the ACCC held it up for a while.

Daniel: Took a couple of years.

Lucas: Yeah, we got there.

Daniel: And Amaysim and Optus got together. And when that industry consolidation occurred, we started to see some more rationality. And we started to see prices start to tick up. Around 2020, 2021. But still today, the industry returns are very low, around two percent And we still think there’s quite a long runway for positive price growth going forward.

Lucas: Yeah. I think that’s absolutely right Dan. It’s an industry that has really struggled to earn its cost of capital back. Now part of that was due to the NBN, which I’m sure you’ll talk about because it really impacted Telstra, but also was a lot of it was self inflicted as you say there there was a price war that lasted about four years. There were no winners. There are never any winners in a price war.

Daniel: No. No. That’s for sure. And we do quite a lot of company contact and what’s been really pleasing over the past sort of couple of years, we’re seeing a lot of incentive plans for management change. In the past, they were really focused on winning market share. And today, it’s really focused on improving returns and improving profitability. So that’s why we’re pretty positive. This sort of market repair on prices has many years to go.

In regards to Telstra, why do we specifically like Telstra? Apart from the dynamic of improving pricing for the whole industry, there’s quite a few reasons why we like the business. NBN has just been such a huge headwind for them over the past several years. It’s been a three billion dollar headwind to earnings, that is now essentially complete. So that three billion headwind is done. And going forward, the business should deliver pretty good earnings growth really from that mobile business predominantly. So that’s sort of a key element. The second thing we like about the business is they own some really high quality infrastructure assets, which we think are sort of undervalued in the share price and probably the best one, the highlight is their NBN rental business where they rent to NBN all the pipes and ducts, which the fibre goes through. And that business earns a billion dollar rental stream which is paid by the government. and that

Lucas: Inflation protected.

Daniel: Yes, by CPI. And, yes, I think this year, the rent is growing at 6%. So that’s, you know, quite a material driver of earnings right now and a high quality earnings stream. And then probably the final thing is the costs of the business are really well under control. In what’s quite a high cost inflation environment, Telstra costs are growing much less than inflation. I think,

Lucas: I think it was 1.6% they reported in the first half. And even more impressively from where I’m sitting is that they stuck to their T25 targets of taking $500 million of fixed cost out of the business. Now they set those targets before inflation took off, so I think it’s really testament to the management team Telstra and the operational efficiencies that they’ve managed to drive within that business.

Daniel: Yes. So we see the industry having good price growth. We see they own some high quality assets. And the outlook for inflation, you know, their cost is well under control. What about TPG? Why do we own TPG in the small cap funds?

Lucas: Yeah. Thanks, Dan. So TPG is a bit of a newer position. We bought in after the merger with Vodafone completed in 2020. And we like it for many of the same reasons that we like Telstra. Obviously, we touched upon why we like the telco sector in general. Clearly, the price outlook for mobile is improving, and that’s gonna drive returns. Dan you touched upon the cost. I think it’s worth highlighting given what’s happening with wages, what’s happening with inflation, that these aren’t really people-heavy businesses. I think Telstra it’s about 30% of their fixed costs are people related. That’s not to say there isn’t some inflation there and there isn’t some inflation in other areas like equipment, but they’re able to keep a lid on it. And with TPG and Vodafone merging as well, they’ve got their cost synergies to come through so that gives another tailwind for them on the cost side. And I think the other thing that we should note with these companies as well is the MOCN deal.

Daniel: Mhmm. Absolutely.

Lucas: So MOCN, as I’m sure, absolutely, no one watching me is aware. It stands for Multi-Operator Core Network. That’s probably not gonna clear things up a great deal. They love their acronyms. Actually every industry we cover they love their acronyms. What it really is is regional infrastructure sharing between Telstra and TPG.

Now firstly, I think it’s a big deal just for the industry. As we’ve touched upon, industry returns have historically been low. They’re improving, which is why we think that it’s a good place to invest. And infrastructure sharing is one way that you can sweat these assets harder. I mean, it really doesn’t make economic sense for three mobile networks to all be rolling out poles, towers, all across Australia’s sparsely populated rural areas. And so therefore, they should work together.

So TPG and Telstra have signed a deal where effectively TPG decommissions a bunch of its towers that it was really underutilising, it will roam onto Telstra’s network in the regional areas. In return, Telstra gets, well, (a) money from TPG. But also, they get access to TPG spectrum, which is important for Telstra because it’s by far the number one mobile network. They do have more congestion on their network, and the spectrum will help alleviate some of that. So we see there’s a real win win for the two of them.

It’s particularly important for TPG because they have had a real network disadvantage outside those metro areas. And not only does that see them under index in regional areas, but it also impacts anyone who lives in a metro area, but then travels a lot, whether it’s for work, for pleasure. I mean, you really notice when your mobile phone gives you one bar and you can’t make a phone call or, you know, look up Instagram. This will give them a product that they can sell in those regional areas. And I think it really is a win win for the two businesses.

It’s clearly not a win for Optus, which is the real loser in this situation. But we think it’s good for the industry overall as well. Now, the ACCC has come out in opposition to that deal. Telstra and TPG have appealed that decision. We think they have a very strong case. We should hear by the end of June whether they’re successful.

But either way, we still like TPG as an investment. We think it’s undervalued. You also touched upon earlier, Dan. Or maybe it was me. I can’t actually remember. Where we spoke about the fact that these companies benefit from larger subscriber bases over time because Australia’s population is growing. Now during COVID, that didn’t happen. A lot of immigrants left the country. We kicked them out. But now that the borders have reopened, that will actually disproportionately help TPG. TPG lost more subscribers on the Vodafone network than their competitors did because they’ve always as the lowest cost operator, as the challenger. Have over indexed with new Australians, international students and the like. Therefore, they should disproportionately benefit now that the borders have reopened. So we do really like TPG for those reasons.

Daniel: Thanks, Lucas. So I guess just to sum up, why do we like the Telco sector? We really do see this price repair or market repair lasting several years in the future because the industry returns are so low. We like that just the general defensive nature of those earning streams. And we think, you know, that’s gonna be pretty well placed whether inflation remains high because they can control that cost base. Or, if the economy does fall into recession, those sort of very defensive earnings streams are gonna hold up quite well. So the stocks are pretty well placed in most economic environments.

Lucas: Totally agree Dan. Thanks for joining us.

Daniel: Thank you.