Korea Telecom

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Includes: AMZN, GOOG, HXSCF, KT, NFLX, SKM
by: Hyundai Motor Investment & Securities
Summary

5G expectations to overshadow regulatory risks.

5G to bring about network evolution and diversification of earnings models.

5G’s ultra-high speed, low latency and massive connectivity should allow telcos to align with a variety of different sectors and connect with unlimited numbers of devices.

Beyond the regulatory horizon is 5G opportunity

We believe telco shares have bottomed out after suffering sharp corrections since the beginning of the year caused by negative sentiment over the implementation of deeper discounts on cell plans and rate reductions for the underprivileged in 2017 as well as worries over the introduction of universal cell plans. We now view the 2H18 telecom sector in a positive light for the following reasons: 1) negative sentiment appears to have been fully priced in during the protracted correction period; 2) universal cell plans, although an ongoing issue, are unlikely to materialize; 3) expectations for 5G services, set to begin in 1H19, will probably grow further, beginning with the spectrum auction in June; and 4) increased dividends after share price declines are likely to provide additional downside support for shares . We like LG Uplus best, followed by SK Telecom (NYSE:SKM) and KT (NYSE:KT).

5G to bring about network evolution and diversification of earnings models

As the key infrastructure of the fourth industrial revolution, 5G will provide the momentum for telcos to pull out of the simple “dumb pipe” status. 5G’s ultra-high speed, low latency and massive connectivity should allow telcos to align with a variety of different sectors and connect with unlimited numbers of devices. This will help telcos to widen their business scope from the B2C to B2B space and diversify earnings models. Some point out that these expectations are unlikely to become reality because device innovations are not catching up with 5G. However, we believe it is premature to lower expectations because we are still preparing for 5G, and 5G itself will evolve over a long period of time. If the recent expiry of “net neutrality” rules in the US somehow affects Korean regulations, it could inject some reality into telcos’ B2B rates on network services.

Expectations outweigh worries in 2H18

Look toward 5G expectations rather than regulatory uncertainties

Telco shares have suffered massive corrections since the beginning of the year. Sentiment has deteriorated due to the implementation of deeper discounts on cell plans and rate reductions for the underprivileged in 2017. There are also lingering worries about the potential introduction of universal cell plans, which many believe will undermine telcos’ fundamentals. The Supreme Court of Korea’s order to disclose telcos’ telecommunications costs as well as the request from an NGO (People’s Solidarity for Participatory Democracy) to disclose LTE costs have also been a negative factor. Although there are no material impacts, the fact that IFRS 15 has changed the accounting standards and made comparisons with past earnings results difficult has also added to the confusion.

We view the 2H18 telecom sector in a positive light, and expect shares, which have already seen the bottom, to move in a positive direction. We are Overweight on the telecom sector and recommend LG Uplus first, followed by SKT and KT.

We view the 2H18 telecom sector in a positive light, and expect shares, which have already seen the bottom, to move in a positive direction. We are Overweight on the telecom sector and recommend LG Uplus first, followed by SKT and KT.

Historically, telco stocks met their major inflection points in the period of: 1) network migration; 2) fluctuating market shares; and 3) regulatory changes. Typically, during network migration, shares tend to rise as expectations grow that ARPU will increase. However, during the transition period from 2G to 3G, ARPU did not increase, and the stock rally was short-lived as a result. On the other hand, the migration from 3G to LTE coincided with the rise of smartphones, which meant a vast array of new services and sharp ARPU growth. The result was a long period of share price strength.

Currently, we are at a very early stage of the LTE-to-5G transition. 5G is slated to be commercially available in 1H19, and the frequency auction for 5G is scheduled for June 15. 5G is the core infrastructure of the fourth industrial revolution and a basic infrastructure that will play a key role not only in the telco sector but in other relevant industries as well. Additionally, through 5G, telcos will be able to determine whether they can expand into the B2B space from B2C. There are concerns that ARPU growth may be limited at an earlier stage of 5G network development due to the lack of killer services. However, considering that the life cycle of the 5G network is expected to be long, and a string of new services will be introduced at later stages rather than earlier stages, expectations for 5G are still valid.

5G to go commercial in 1H19

5G, the core infrastructure of the fourth industrial revolution

As the core infrastructure of the fourth industrial revolution, expectations are high that 5G will play a key role in bringing about fundamental changes in telcos’ business models. In other words, these are the expectations that 5G will help telcos to extend beyond the mere “dumb pipe” role and will provide opportunities to advance into the B2C space by expanding business coverage. 5G’s ultra-high speed, low latency and massive connectivity should allow telcos to align with a variety of different sectors and connect with unlimited numbers of devices. This will help telcos to widen their business scope from the B2C to B2B space and diversify earnings models. Also, if the recent expiry of “net neutrality” rules in the US somehow affects Korean regulations, it could inject some reality into telcos’ B2B rates on network services.

However, some think that it is still early for these expectations to turn into reality. The transition from 3G to LTE coincided with IT device innovation, notably the rise of smartphones. However, as we head into the 5G era, there are no signs of such device innovations. Also, the services to be offered through 5G do not appear to be very different from the services provided in LTE. Nevertheless, we believe it is too early to withdraw our expectations for the 5G era. Given that this is only a preparatory stage for 5G services, the types of services to be offered in 5G will be diversified further with the evolution of 5G. Telcos' earnings base is also expected to diversify.

As for the 5G technology standards, the ITU and 3GPP (3rd Generation Partnership Project) agreed on the NSA (non-standalone) architecture for initial stages of 5G in December last year. Afterward, in June 2018, the 3GPP approved the 5G standalone (NYSEMKT:SA) specification as global standard. While the NSA standard focuses on converging LTE and 5G for optimal performance, the SA standard is a technology specializing in 5G data transmission, without linking LTE. With the completion of global technology standards, efforts to develop 5G terminals and devices and to build network will likely accelerate. Domestically, there will be frequency auction for the 5G service and 5G network building is to begin in earnest in 2H18.

5G spectrum auction bidding starts at KRW3.27tn

The 5G frequency auction is composed of two bands: a 280MHz in the 3.5GHz range will be used for 10 years with a starting bid of KRW2.65tn; a 2,400MHz of the 28GHz range is for five-year use with a starting bid of KRW621.6bn. The sum of the starting bids is KRW3.27tn.

The clock auction method will be used for the spectrum auction. The auctioned frequency will be divided in blocks of 10MHz (for the 3.5GHz spectrum) and 100MHz (for 28GHz). The first stage will determine bandwidth and the second stage will determine spectrum position. For example, in the first stage, the 3.5GHz spectrum will be divided into 28 blocks and the 28GHz spectrum will be divided into 24 blocks. Then the three carriers will bid the number of blocks they want, and if the number exceeds 28, the bidding will proceed to the second and third rounds with higher bidding prices. Since the maximum bandwidth that a carrier is allowed to have in the 3.5GHz spectrum is limited to 100Mhz, the number of blocks assigned to the three telcos in the 3.5GHz range would be either 10/10/8 or 10/9/9.

After the number of blocks for each telco is set, the second stage will decide the position of the spectrum through a sealed bidding. There are six case scenarios—SKL, SLK, KSL, KLS, LSK, LKS—and the highest bidder will choose one of these six (S: SKT, K: KT, L: LG Uplus). After the spectrum allocation, telcos have to build some 150,000 cell towers for the 3.5GHz spectrum, which is enough to build a nationwide LTE network (15% completion in three years and 50% in five years). For the 28GHz spectrum, telcos are required to finish building 15% of the required network in three years.

On the first day of spectrum auction (June 15), the auction on bandwidth did not finish. The bidding for the 28GHz range closed at the lowest bid in the first round, but the bidding for the 3.5GHz spectrum proceeded to the sixth round. The current price per block (10MHz) is KRW95.7bn, which translates to a total of KRW2.68tn. This is a 0.95% increase from the starting bid. The next auction will be held on June 18. After the bandwidth auction for the 3.5GHz range is complete in the first stage, the second stage will decide the position of frequency. Since the auction provides new frequencies, adjacent and nearby frequency bands are not offered, which lessens the importance of the second stage auction which decides frequency position. So the first stage auction that determines bandwidth is more important. Of note, the auction will allow 50 rounds of bidding.

From a broad perspective, we do not expect competition to heat up since the starting bid is already set at a pricey KRW3.27tn. However, with the auction still ongoing, it remains difficult to predict the results. The results of the auction will vary depending on how many blocks the three telcos decide to take.

Regulatory issues to have limited impact

Universal cell plan still a risk but unlikely to materialize

The universal plan, which offers 1GB of data and 200 minutes of voice calls per month at about KRW20,000 per month, is one of the policies strongly promoted by the regulatory authority. The amendment to the Telecommunications Business Act for the introduction of the universal plan passed the Regulatory Reform Committee in May and is to be submitted to the National Assembly. If the amendment passes parliament, the Minister of Science and Technology will make the final decision on the data/voice rate provided by the universal plan every two years, after consulting with relevant parties.

Although the government’s push for the universal cell plan is strong, there is a lot of controversy over whether the government should artificially determine market prices. Some point out that the introduction of the universal cell plan can hamper telcos’ investments in 5G; also, it is widely believed that it will threaten MVNO operators’ existence. Recently, telcos have introduced a string of new cell plans that are similar to the universal cell plan. It is part of a strategy to stave off regulatory pressure by taking preemptive action.

Given the recent circumstances, the introduction of universal cell plan is unlikely to become a reality. Although the universal cell plan is a lingering risk factor, it will face a lot of difficulties before being fully implemented.

Pay TV M/S cap to be lifted, M&As among CATV SOs to gain steam

On June 27, 2018, the law regulating the market share of pay TV operators will be repealed. The law limits a pay TV operator’ market share to 33% in terms of total subscribers. It was introduced in June 2015 and was to be in effect for a limited period of three years. There are currently no discussions as to whether to extend or amend the law. Thus, unless something unexpected happens, from June, pay TV operators will be able to acquire subscribers even if their market shares exceed 33%. Going forward, we may see significant M&A activities in the pay TV market.

In the pay TV market, IPTV operators are chipping away at the market share of CATV SOs. When the upper limit on pay TV operators’ market share is lifted, KT Group will likely move to further strengthen its leadership in the pay TV market through aggressive subscriber acquisition or M&As. SK Group, which failed in its attempt to acquire CJ Hellovision in 2016, is also aware of the importance of a media platform in the 5G era. LG Uplus is also working hard to gain strength in the media business, as shown by its recent partnership with Netflix. It has also shown interest, albeit unofficially, in acquiring CATV SOs.

CATV SOs are also showing great interest in selling their companies. CJ Hellovision, the largest SO, tried to sell the company two years ago, only to be rejected by the authority. Given the recent merger of CJ E&M and CJ O Shopping, selling CJ Hellovision remains an option. D’LIVE is also reportedly seeking M&A opportunities, including a sell-off. The saturated pay TV market that calls for restructuring and shared interest of buyers and sellers will work to fuel M&A momentum. Of course, the upper limit on market share has to be resolved first but we do not believe policy makers will stop voluntary M&A attempts among SOs.

Will net neutrality expiry in the US affect policy in Korea?

Network neutrality policy has very important implications in the 5G era. Network neutrality means that all network operators should treat all content and services equally and not discriminate. It is more reasonable to understand it as a concept that combines network diversity and network fairness rather than literally as neutrality. It is a debate on the extent of duties and rights of telcos in terms of traffic management, in addition to the issue of who will pay for the network that they built. Opinions on net neutrality vary sharply by all the parties concerned, such as content providers, platform providers, and device manufacturers.

The US has recently abolished net neutrality that was introduced under the Obama administration. The FCC decided to officially repeal net neutrality as of June 11, after regulators voted to end rules protecting an open Internet in December 2017. This gives legitimacy to telcos when they offer premium services and manage traffic. What this means for content providers such as Google (GOOG), Netflix (NFLX), and Amazon (AMZN) is that they may have to pay for the network.

In Korea, the network neutrality guidelines implemented by the Korea Communications Commission in December 2011 are still alive, which stipulate transparent traffic management and prohibition of network access denial and unreasonable traffic discrimination. The current administration intends to maintain existing net neutrality rules but is willing to study how it will deal with net neutrality heading into the 5G era. The US telecom policies which recognize telcos’ interest in charging for network usage will not be exactly applied to the domestic market, but there are expectations that there will be some changes. At this point, it is still unclear whether the net neutrality rules will change. Two bills—one that proposes to mitigate net neutrality and the other that proposes to strengthen it—are currently being introduced in the National Assembly.

Network neutrality is a debate to determine the scope of telcos’ duties and rights when it comes to traffic management. All parties associated with this matter have different opinions: some promote implementation of strict network neutrality rules while others believe telcos should have a higher degree of autonomy when managing their core businesses and network. In the end, the question of what logic should be applied at what point is strictly up to regulators, and the rules that fit the situation of each country will have to be applied, in our view.

SK Telecom

Noting the possibility of intrinsic value realization

SK Telecom shares are still punitively valued because of the sluggish core business and regulatory risks, which have weighed on sentiment over the telecom sector. We would, however, look toward the possibility of SKT taking leadership in the 5G era rather than focusing on uncertainties over additional rate cuts. The margin outlook is weak because of cost burdens associated with 5G network preparations and the fourth industrial revolution as well as the stagnant wireless revenue. The value of less-known business divisions with strong intrinsic value now needs to be recognized into earnings. This is the reason that we note the company’s potential corporate governance reshuffle, which has been a topic of discussion in the market.

Earnings from wireless telecom, the company’s cash cow, will likely remain weak in the short term due to cell plan discounts and 5G services which will take a long time to roll out. We are however positive that cost concerns over 5G investments are low and competition remains limited. Competition in the e-commerce market is still fierce. However, we expect SK Planet’s profitability to gradually rise given its economies of scale, seeing the limited marketing capacity of overall social commerce companies and 11street’s growing billings. Indeed, 11street’s marketing cost to sales improved by 9%p YoY to 27% in 1Q18. Meanwhile, SK Broadband’s media business continues to grow. Increasing equity-method income from SK Hynix (OTC:HXSCL) and the prospect of higher dividends are also notable.

KT

Trading at a historically low P/B

Despite relatively strong earnings performance, KT shares are trading at a historically low P/B due to deteriorating sentiment over the telecom sector. We believe it is time for the stock to price in such positives as recovering competitiveness in wireless telecom, the rising ARPU of broadband Internet led by GiGA Internet, and strong IPTV performance. Expectations for further growth upon the introduction of 5G services are still intact. Regulatory risks remain but are mostly priced in. We see potential for further growth of the media business if the law restricting the combined market share of pay TV operators is terminated. IPTV and satellite TV, each based on different technologies, put KT in an advantageous position to take the leadership in the media market if regulatory conditions change.

The rising number of wireless subscribers and steady growth of fixed-line telecom help to offset, albeit partly, the negative impacts of deeper discounts on cell plans and rate reductions for the underprivileged. 1Q18 net-added 363,000 subscribers, the highest quarterly number since 2013. Fixed-line revenue is holding up well, with the exception of PSTN revenue. GiGA Internet subscribers’ share has risen to 49%, contributing to ARPU growth. IPTV is also doing well, helped by steadily increasing subscribers and higher ARPU. Along with earnings, dividends are expected to increase as well.

We believe KT will continue to put out better earnings figures vs. others. Despite low valuations, regulatory risks continue to dampen share price performance. However, we think it is time for the stock to move to price in expectations for the future as we move closer toward the 5G era. Accordingly, we maintain BUY and our target price of KRW37,000.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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