SK Telecom: Competition Hurting Bottom Line

SK Telecom (SKM) Q4 2007 update:

Financial results

• SK Telecom grew operating revenues 4% and 6% for Q4 and full year 2007, respectively, to 2.9T(rillion) KRW and 11.3T KRW. Unfortunately, operating expenses more than outpaced revenues, increasing ~14% for both the quarter and the year. Operating income for the year fell 16% to 2.2T KRW, with operating margin falling 5 percentage points to 19%.
• In a worrisome development, operating expenses and in particular, marketing expense, jumped sharply. Marketing commissions increased 17% from last quarter and 35% for the year. This accounts for the bulk of the hit to operating margins.
• The company achieved 1.7M net adds with a churn rate of 2.5%, up 50 bp from last year.
• ARPU and MOU showed slight increases from last quarter but finished basically flat YoY.
• As expected, capex spending accelerated as the company pulled 2008 spending into the current year, mostly to build out WCDMA (3G) network capacity.

Whatever the company's expectations for the "rationalization" in the domestic competitive landscape, the results speak for themselves. SK Telecom managed to maintain their leading market position but at the expense of operating margins. Based on the conference call, this trend can be expected to continue into next year as the handset subsidy ban expires and competition for 3G subscribers hots up. According to this article and management's own inferences, SKT are trailing KT Freetel in total 3G subscribers. I would like to see this gap closed and going the other way by YE 2008.

SK's CEO sat in on this most recent conference call and while he was as elusive as other execs on previous calls, he did provide insight into some of the key drivers for the company in the near term.

First, it is clear that the Hanarotelecom acquisition is an important building block toward consolidating their market-leading position as SKT's lack of wired infrastructure hampers their ability to offer bundled services. Management doesn't anticipate any anti-competitive issues to derail the acquisition but when it comes to government regulation, nothing is certain.

Second, competition for WCDMA (aka 3G) subscribers will remain quite fierce. Reading between the lines, we can expect further pressure on operating margins as management mentioned the high cost of 3G handsets and with the handset subsidy ban expiring, this would appear a logical point to attract new subs. Despite the company's assertion that SKT will use its market-leading position to hold the line on marketing costs, I expect marketing expense will increase in 2008. The CEO declined to give guidance on marketing expense ratio or EBITDA.

Third, returns from the company's global investments are nebulous at best in the near-term. Management set subscriber targets of 5M in Vietnam but apparently, there may be some issues with relations with the company's partner in that market. The U.S. Helio venture has 185 thousand customers and has lost 145B KRW thus far. Positive FCF is projected by 2010. The China strategy is up in the air as the government decides what to do with China Unicom. My original assessment to completely discard the company's global plays seems correct but I will watch the Vietnam S-Fone situation closely.

With these drivers in mind, below are the revised performance measurements. While operating results may be poor in the near term, I expect the company to eventually reassert its market dominance and restore margins once the 3G market stabilizes. All of this seems to be keyed on the Hanarotelecom acquisition as the ability to offer bundled services is probably a key competitive tactic. If this acquisition hits troubled waters, I will need to re-evaluate SKT going forward.

2008 Guidance

• Revenue 11.7T KRW
• CapEx 1.75T KRW
• ~1M net adds
• No targets given for EBITDA, ARPU or marketing expenses so assume downside as a given

Performance Measurements

• Hanarotelecom acquisiton approved
• 2008 FCF ~1.7T KRW
• Marketing expenses increased but as a result, I'd expect to see SKT match or exceed KTF's 3G subscriber numbers.
• Keep market share stable or slightly increasing.
• Vietnam S-Fone venture negotiations settled.

Disclosure: Author has a long position in SKM