StarHub: Competition Is Key Structural Issue Depressing Valuations

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About: StarHub Ltd (SRHBF)
by: The Value Pendulum
Summary

StarHub's 2Q2019 results suggest multiple headwinds, albeit with some bright spots suggesting possible recovery in 2H2019.

Competition remains the key structural issue for its mobile, pay TV and enterprise businesses.

The company's 6.5 times consensus forward FY2019 EV/EBITDA and 6.2% dividend yield suggest value, but the reality is that fundamentals could worsen due to competition.

Elevator Pitch

Singapore-listed telecommunication services operator StarHub Ltd. (OTCPK:SRHBF, STH:SP) is currently trading at an undemanding 6.5 times consensus forward FY2019 EV/EBITDA and offers an attractive 6.2% dividend yield, based on its share price of S$1.45 as of August 8, 2019. The stock's cheapness is attributed to multiple headwinds that the company is facing.

StarHub faces serious competition from MVNOs (Mobile Virtual Network Operators) in the mobile segment, and competition could further intensify with the official entry of Australia-based TPG Telecom (OTC:TPGTF, OTC:TPPTY) into the Singapore mobile market this year. The company's enterprise segment, more specifically the network solutions business, is also witnessing more price competition, while its cybersecurity business is still loss-making. StarHub also lost some pay television subscribers due to the recent cable-to-fiber migration.

Looking ahead, there could be further downward pressure on its earnings and dividends assuming competition intensifies in the various business segments, implying that the company is not really undervalued despite the apparent cheapness.

Company Description

Started in 1998, StarHub is the second-largest mobile services operator in Singapore with a market share of 26.2% as of end-March 2019. The other two mobile operators in the country are Singapore Telecommunications Limited (OTCPK:SGAPY, OTCPK:SNGNF, ST:SP) and M1 Limited (OTC:MBOFF, OTCPK:MBOFY) with mobile market shares of 49.3% and 24.5% respectively. StarHub is the largest pay television operator with 374,000 subscribers in Singapore, having entered the business with the acquisition of Singapore Cable Vision in 2001. StarHub was the only pay television operator in Singapore till the launch of pay television services by Singapore Telecommunications Limited in 2007.

StarHub generated approximately 43%, 15%, 10% and 31% of its 1H2019 service revenue from its mobile services, pay television services, broadband services and enterprise businesses respectively.

Headwinds Persist

StarHub's 2Q2019 financial results released on August 6, 2019, suggest that the company continued to be under pressure from multiple headwinds. The company's 2Q2019 revenue declined 7.4% YoY to S$552.8 million, as segment revenue for the mobile services, pay television services and broadband services businesses decreased -9.9%, -23.2% and -2.2% YoY in the same period respectively. StarHub's enterprise business segment saw revenue grow 14.6% YoY to S$140.3 million for 2Q2019, but this was the result of a -4.2% YoY decline in network solutions revenue offset by a 161.4% growth in cybersecurity services revenue.

For the mobile business, competition from MVNOs have been increasing (more than 12 brands operating in the market now, according to StarHub) since MVNOs Circles.Life, Zero Mobile, Zero1 and MyRepublic launched their services in May 2016, December 2017, February 2018 and May 2018 respectively. Some of the more aggressive mobile plans offered by MVNOs include unlimited 4G mobile data plans subject to fair use policies.

Pay television, or pay TV, revenue was down -23.6% YoY to S$64.7 million in 2Q2019, largely due to a lower pay TV subscriber base of 374,000 customers as of end-2Q2019 versus 438,000 and 394,000 pay TV subscribers as of end-June 2018 and end-March 2019 respectively.

Due to the decommissioning of cable infrastructure, StarHub had to migrate some of its pay TV subscribers from cable to fiber, which led to increased subscriber churn. The average pay TV subscriber monthly churn rate was 2.1% for 2Q2019, significantly higher than 1.5% for 1Q2019 and 1.1% for 2Q2018. To encourage its pay TV subscribers currently on cable to go through the migration program, the company also offered promotions, which resulted in a -11% decline in ARPU (Average Revenue Per User), from $53 in 2Q2018 to $44 in 2Q2019.

The enterprise business is a key growth driver for StarHub, accounting for 31% of 1H2019 revenue. With the enterprise business segment, the network solutions sub-segment is the most significant revenue contributor, representing 77% of enterprise business segment revenue for 1H2019. Therefore, it is concerning that the network solutions business recorded two consecutive quarters of QoQ revenue decline in 2Q2019 and 1Q2019.

StarHub explained why network solution revenue was declining at its 2Q2019 results briefing on August 6, 2019:

What we're seeing in the enterprise market is predominantly when contracts are coming up for renewal, it's a fairly competitive process, and there's price erosion. Corporate customers have an expectation because of how much they spend with companies like us and our competitors to get better value, and typically, they will recontract and either pay the same price but get more bandwidth, more services, or they will go for a straight discount. So we've seen a number of contracts being renewed at a lower price point and thus contributing quite a bit of the revenue decline this particular quarter.

The company's cybersecurity service sub-segment did well, growing revenue contribution 161.4% YoY, from S$13.8 million in 2Q2018 to S$36.2 million in 2Q2019. But, unfortunately, the cybersecurity business remains loss-making.

Bright Spots In 2Q2019 Set The Foundation For A Better 2H2019

There were some bright spots within StarHub's 2Q2019 results, which could set the foundation for an improved 2H2019.

With respect to the mobile services business, StarHub did reasonably well on a QoQ basis with some signs of stabilization seen. Its post-paid mobile subscriber base increased 3% QoQ to 1,477,000 with 39,000 net additions in 2Q2019, while its pre-paid mobile subscriber base remained relatively flat at 789,000. Post-paid mobile ARPU and pre-paid mobile ARPU grew 2% and 7% QoQ to S$40 and S$14 respectively for 2Q2019.

This could be partly attributable to the success of StarHub's HelloChange marketing campaign launched in December 2018 with the introduction of new contract-free mobile plans, reduction of the number of mobile plans available for selection to just three, and the removal of hidden charges, such as the previously chargeable add-on services Caller Number Display and International Roaming come free with the new mobile plans.

For StarHub's pay TV business, the worst of the negative impact from the cable-to-fiber migration should have been seen in 2Q2019. The company has guided that the cable-to-fiber migration program will be completed in 3Q2019. With the bulk of migration costs being recognized (and the migration of most of the cable subscribers to fiber) in 2Q2019, StarHub's 2H2019 and especially 4Q2019 should be free of cable-to-fiber migration costs (absorbed by the company due to regulatory factors) and also see the easing of pay TV subscriber churn.

Furthermore, StarHub's pay TV business could experience an improvement in profitability for 2H2019 as it negotiates with content providers to shift its content costs from a fixed basis to a variable basis (content costs varying with subscriber base and subscriber revenues rather than a fixed quantum). The company elaborated on this in its 2Q2019 earnings call:

If you look at the cost of services component, despite the increases that we had in enterprise services, as well as the payments for migration to fiber, we've recorded lower content costs as well... In terms of contracts for content management, we're still negotiating one final contract. By the end of September, those negotiations will be over. Again, we will comment when the negotiations are over. I think it's only fair and professional not to comment in between. But the point I want to make is we're still committed to doing two things with content. First of all, having the lowest possible content, but on top of that, having a variable content model, where we pay per customer for content rather than a fixed cost for content, irrespective of the customers... Pay TV, as I mentioned again, we don't give out margins, but what we've been doing with pay TV is renegotiating and bringing the cost of content down as far as we can and making it variable... We've offered low pricing points, so we will continue to manage the content costs down, but margins are improving, but I don't believe - if we don't see the revenue stabilizing as well, eventually, that has an impact on the margins

With regard to the enterprise business segment, StarHub will try to mitigate the impact of pricing pressure on the network solutions sub-segment by capturing a larger share of its enterprise clients' wallet. Leveraging on its existing mobile and fixed-line business contracts and relationships with many enterprise clients in Singapore, StarHub continues to cross-sell a full range of enterprise solutions, such as data services, cloud services, unified communications and cybersecurity services.

For StarHub's cybersecurity services, apart from the strong 161.4% YoY growth in revenue for 2Q2019, the cybersecurity business' profitability is also improving. Losses narrowed from S$12 million in 1Q2019 to under S$1 million for 2Q2019 due to the absence of one-off costs in 1Q2019. But more importantly, the company expects losses for the cybersecurity business to stabilize at 2Q2019 levels close to breakeven for 2H2019.

While 2H2019 could show improvement from 1H2019, I am more concerned about the company's earnings and dividend sustainability over a longer period, which is the subject of the next section.

Competition Is The Key Structural Issue

StarHub is suffering from intensified competition in all of its key business segments, which creates uncertainty over future earnings.

At the 2Q2019 earnings call on August 6, 2019, the company acknowledged the possibility of increased mobile competition, especially from MVNOs, in coming quarters:

First of all, is there scope for mobile competition? We don't think there is, but obviously the owners of other companies believe so and they keep entering the market, because we've seen some new MVNOs, and from what we understand, potentially there's some more MVNOs to enter the market in the second half. The markets again, if you look at all the free offers from some of the new entrants, some of them have a free offer for a year. Others have the first month is free. All these new entrants unfortunately using this pricing strategy or freebie for at least a month if not a year. That's taking away revenue from the mobile pie in addition to the simplification of charges, removal of excess charges. So the overall pie, we believe, is shrinking for mobility and the more companies that are coming in, they're slicing up mobility into even smaller chunks. So we don't think there is - customers have tremendous choice today, price points, bundled and unbundled packages, with SIM only, or with SIM and a handset, different brands, different roaming arrangements, so we think the market is very, very well served. There's at least - I stopped counting after 12 or 13 different brands in the market, so the customer is served well, and the marketplace is very competitively, but there's still some companies that see an opportunity, and they're entering the market. Of course, we can't control who enters the market. We can control how do we compete and offer value, position the brand well, make sure our distribution capabilities are right and use leverage both of bricks and mortar, our retail shops and also the digital platforms that we've developed. So we see competition in mobility continuing for the next few quarters, and then of course fundamentals of marketing say that it is not sustainable if some of the competitors don't win a big share of the market and they have a certain cost. So we don't think there's scope for more competition, but as I said, every quarter, we're proven wrong because more and more new entrants are coming in.

Besides the potential entry of more MVNOs in 2H2019, which StarHub highlighted above, new entrant and Singapore's fourth mobile services operator, Australia-based TPG Telecom (OTC:TPGTF), is expected to officially launch its mobile services later this year after starting a free 12-month trial in December 2018. TPG Telecom was awarded the fourth national mobile operator licence in 4Q2016.

In Fitch Solutions' 3Q2019 Singapore Telecommunications Report published in July 2019, it highlighted the competitive risk that TPG could pose:

We note that TPG will launch in an already fiercely competitive market which is becoming increasingly crowded given several recent MVNO launches. The market is already highly developed and TPG will have to offer high quality service for low prices to lure customers from their existing plans... With this activity in the MVNO sector, and TPG's launch on the cards, the existing operators need to ensure their mobile offers remain innovative and perceived as good value. The three incumbents have responded with the launch of very competitive SIM-only (bring your own device) post-paid plans... StarHub's ARPUs after adoption of the new SIFRS15 standards have trended significantly lower allowing M1 to narrow the gap, although SingTel maintains its ARPU leadership. We would expect further dilution when TPG enters the market.

With more new MVNOs and TPG joining the fray, competition in the Singapore mobile market is likely to intensify in coming quarters, suggesting that mobile ARPUs could continue on a downwards trend. There is nothing to stop competitors from replicating each other's mobile plans and offerings, so there is no unique competitive advantage that any mobile operator possesses.

In terms of pay TV, putting the recent cable-to-fiber migration program aside, consumers increasingly have more options for both paid and free viewing content (e.g., Toggle for local shows, Viu for Korean dramas, Crunchyroll for animation, Netflix (NFLX) and Amazon Prime (AMZN) for Hollywood movies and international TV shows, etc.), so it would be an achievement for StarHub to merely slow down the pace of pay TV subscriber attrition.

Furthermore, exclusive content is no longer a competitive advantage for Singapore pay TV services operators since 2013, where a cross-carriage law was put in place stipulating that exclusive content acquired "must be cross-carried in its entirety and in an unmodified/unedited form, and that the content be made available to consumers at the same price as other qualifying pay TV operators’ viewers."

With respect to the enterprise and network solutions business, StarHub similarly has to fend off increased competition. Competitors in the enterprise business in Singapore include other telecommunication companies such as Singapore Telecommunications Limited and global system integrators like Dimension Data, among others. Also, global systems integrators with offices worldwide have an edge over Singapore-centric players like StarHub in competing for the business of multinational corporations, which would likely prefer a single global vendor.

Larger companies are also tightening on their procurement costs in a difficult economic environment and bargaining hard on price for both new contracts and existing renewals. The strong bargaining power of large corporates is not merely due to their huge budgets, but also the fact that there are a lot of suppliers of enterprise services in the market. Enterprise services providers such as StarHub have limited pricing power as a result.

At the 2Q2019 results briefing, StarHub elaborated on the competitive pressures it has to deal with:

With some of the large customers, they're leveraging their spending with any supplier. They have tremendous procurement teams. Corporates these days are making very sophisticated purchasing decisions on quality, on price, on functionality for the future, so in a tough economic environment, it's to be expected, especially the procurement departments of corporate customers, to be a bit tougher... The enterprise price pressures, again, in Singapore, we have a lot of different providers of enterprise solutions. For basic connectivity, it's definitely Singtel (Singapore Telecommunications Limited) and us predominantly, although there are other international organisations, telecommunications companies that buy wholesale capacity from us and provide such to their customers as part of global networks. So there is tremendous choice for multinationals to shop around and sometimes we're seeing price pressure, where there's a global pricing to a global bank based in New York or based in Europe or somewhere else, and there's global pricing, and that might affect the local pricing as well. So we're also seeing systems integrators, ICT customers, global names, Dimension Data and many others, not to mention anybody specifically, so the corporate market is well served, both on connectivity and solutions, and often, it's bundled by some of the global providers, and that might put a little bit of pressure.

The company had a good summary of the key structural issue - competition - impacting its core businesses at the 2Q2019 earnings call:

So both whether it's mobility, whether it's TV, whether it's the enterprise markets, Singapore is served very well today by multiple providers and multiple propositions for customers and certainly customer is king or queen, whether it's consumer or whether it's enterprise right now.

In other words, StarHub's clients for its various businesses all have a fair amount of choices for their needs (largely commodity services with no lack of providers), which leads to weak bargaining power for the company and difficulty in raising prices and maintaining profitability.

Valuation

StarHub trades at 6.5 times consensus forward FY2019 EV/EBITDA and 6.7 times consensus forward FY2020 EV/EBITDA based on its share price of S$1.45 as of August 8, 2019. The stock also offers a 6.2% dividend yield, assuming a quarterly dividend of S$0.0225.

Variant View

Upside risks for StarHub include more benign competition in the mobile, pay TV and enterprise segments, TPG Telecom gaining less traction with Singapore consumers and lower-than-expected content costs following successful negotiations.

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.