We are downgrading our telecommunication sector call to NEUTRAL (from OVERWEIGHT previously) in view of: (i) intensifying competition, especially in the prepaid segment, (ii) potential margins pressure as a result of the higher customer acquisition costs (via heavy handset's subsidies), and (iii) higher marketing costs to retain market share which may further pressure profitability. The continued growth of the tier-2 celcos as well as the entry of two muscular MVNO players could lead to the big telcos facing intensifying competition in the prepaid segment. While celcos believe the upcoming GST implementation could allow players to execute the prepaid tax pass-through scheme, there is a possibility that the authority may request the incumbents to continue the subsidies, in our view, given the rising cost of living, hence neutralising the earnings impact. Valuation-wise, there is no change in our telecommunication companies FY13-FY14 earnings forecasts. Telekom Malaysia (OP, TP: RM5.94) is our top pick for the sector due to: (i) its solid presence in the FTTH market, (ii) lesser competition in its wholesale and fixed-line segment, and (iii) it is a key lagging index mover YTD. We are maintaining our MARKET PERFORM calls on both Maxis (TP: RM7.32) and Axiata (TP: RM6.70). Meanwhile, we are downgrading our Digi rating to MARKET PERFORM, in view of its recent healthy share price performance, with an unchanged target price of RM5.24. Similarly, we are upgrading our Redtone call to OUTPERFORM with unchanged fair value of RM0.81, in view of the potential 14.1% capital upside from here.

The availability of LTE-FDD/TDD network convergence could provide opportunities for spectrum starved players, especially Digi, to improve and balance their spectrum portfolio. We believe mobile incumbents are likely to enter smart partnership/network sharing agreement, if any, instead of outright acquisitions of spectrums from rivals.

Neutral impact on GST implementation.  At first glance, the upcoming GST implementation could benefit the Celcos (if the subscribers' usage behaviour remains unchanged) given that the mobile incumbents would be able to pass through the prepaid service tax to the prepaid users. Nevertheless, we are neutral on the potential impact given the possibility for the government requesting celcos to continue subsidising the prepaid service tax in view of the rising cost of living. Note that, the authority had previously been using a similar reason to deny the tax transfer to prepaid users in late 2011.

Newbies in MVNO set to compete with big telco. Telin, a subsidiary of Indonesia largest telco operator – Telkom Indonesia, has recently entered into a MVNO agreement with Maxis to provide prepaid services for the foreign immigrant market, especially the Indonesian community in Malaysia. Meanwhile, Altel Communications S/B (or formerly know as Puncak Semangat S/B), is another MVNO player via a partnership with Celcom Axiata. The group was reportedly aiming to become a full-fledged telco once its own infrastructure is in place to roll out 4G broadband services.

Intensifying competition in the prepaid market. The aggregate of the total tier-1 local celco companies (i.e. Maxis, Celcom Axiata, and Digi) subscribers’ net adds have continued to shrink for the two consecutive quarters. To a certain extent, we believe the drop was mainly led by the migration of the lower prepaid subscribers to U Mobile and other MVNO players. Going forward, the segment competition is expected to heat up in view of more muscular MVNO players (i.e. Telin & Altel) entering into the prepaid market, albeit the impact should be minimal during the initial stage.

Digi’s Business Trust listing may be a neutral affair after all. While Digi continues to remain silent on its BT feasibility study progress, the proposed structure could turn out to be a double-edged sword, in our view. Although the move could improve its dividend payout via its strong operating cash flow, the impact could be neutralised should Digi intends to raise fresh funds from the capital market. Under the above scenario, existing shareholder's interest are likely to be diluted (should the share dilution impact is higher than the dividend improvement), thus positioning Digi for a de-rating over the long term.

2QFY13 results snapshot. Most of the local telco players posted 2QCY13's results that came in within our expectations. TM is the only outperformer during the quarter due to its higher data and internet revenue as well as lower operating costs; MAXIS’ top line remains muted but cushioned by lower-than-expected costs. Similarly, Digi's performance was mainly fuelled by the higher margin led by the continued improvements in its network quality as well as larger 3G network footprints, despite recording a relatively flat revenue growth on a QoQ basis. AXIATA, on the other hand, saw its 2QFY13 results pressured by forex volatility and lower contribution from its Indonesia operation. Redtone, meanwhile, recorded a 10-fold earning's jump in FY13 as per our earlier prediction, thanks to the strong data revenue contribution as a result of synergistic benefits being created through the collaboration with Maxis.

Benefiting from the upcoming GST implementation? At first glance, the upcoming GST implementation could benefit the celcos given that the mobile incumbents would be able to pass through the prepaid service tax to the subscribers. Digi stands to benefit the most (assuming consumer’s usage behaviour remain unchanged) under the above scenario given its largest prepaid revenue base at 79% of its total mobile revenue as compared to 61% in Celcom and 47% in Maxis. Nevertheless, we are neutral on the potential impact given the possibility for the government requesting celcos to continue subsidising the prepaid service tax in view of the rising cost of living. Note that, the authority had previously been using similar reason to deny the tax transfer to subscribers in late 2011.

The convergence of LTE-FDD/TDD network. The global TD-LTE Initiative (GTI) had on February 2013 provided an update on successful global roaming trials between major wireless operators in the U.S., China and South Korea to promote a unified LTEFDD/TDD market, according to Clearwire Corporation, a leading 4G wireless broadband service's provider in United States. The GTI’s successful roaming trials between LTE-TDD and LTE-FDD network technologies marked a major step towards providing worldwide inter-operable LTE services. With the introduction of LTE-TDD and its convergence development with LTE-FDD, LTE has realised utilizing both TDD and FDD spectrum with one unified solution. The service will provide a great convenience for LTE service subscribers to enjoy high speed mobile data roaming service across different networks no matter whether TDD or FDD spectrum is applied.

Note that, GTI was formed by leading global operators to create value for stakeholders across the LTE-TDD ecosystem for early adoption of the technology and convergence of LTE-FDD and TDD. GTI includes more than 50 operators around the world (i.e. China Mobile (mainland China and Hong Kong), SoftBank (Japan); KT (Korea), Bharti Airtel (India) and etc.), and dozens of leading technology partners.

Malaysia’s mobile spectrum landscape. The coverage and growth of the telecommunication operators, to a certain extent, is very much dependent on the size and frequency of the allocated spectrum bandwidth. Both Celcom and Maxis, who have extensive amount of spectrums are the country’s largest top two mobile operators (in terms of subscribers). Digi, on the other hand, has always being the spectrum starved player due to its ‘limited’ spectrums as compare to its major two competitors coupled with a relatively late deployment of its 3G services, thus resulting in the group having a smaller 3G coverage of 75% (as of August 2013) as compared to Maxis and Celcom (>80%).

4G LTE landscape. The network sharing between Maxis, Redtone and U Mobile on their respective 4G LTE networks have made the MAXIS having the largest combined LTE spectrum of 60MHz, enabling the company to offer the fastest 4G broadband speed in the country of up to 150Mbps. Meanwhile, the master collaboration agreement between Celcom Axiata and Altel Communications S/B in July 2013 will result in a combined with a total 40MHz in the 2.6GHz band. The combine spectrum could go up to 60MHz, at par with Maxis combined spectrum, if Altel agreed to join its remaining 2x10MHz into the pool. The latest corporate movements have put Digi at a disadvantage in terms of the spectrum size. We understand that Digi is constantly looking for ways to improve the balance of their spectrum portfolio and would evaluate all opportunities to do so. We believe, to overcome the above-mentioned spectrum scarcity, Digi could improve its 4G LTE services coverage/quality via different approaches, such as: (i) to achieve optimal or efficient spectrum management (should the authority allows the group to deploy its LTE services under the different spectrum bands i.e. 900MHz; 1800MHz and/or 2100MHz), (ii) strategic acquisition/collaboration with other spectrum owners, and/or (iii) to apply for the upcoming digital dividend in the 700MHz that is going to be freed-up by the country’s DTTB (“Digital Terrestrial Television Broadcasting”) project.

We believe the top two approaches appear feasible for Digi under the current scenarios. Efficient spectrum management and the government approval will be its key challenges should Digi intends to opt for the fist approach. Meanwhile, if Digi decided to go for strategic acquisition/collaboration with other spectrum owners; pricing as well as the development of LTE-FDD/TDD ecosystem will be key considerations, in our view. We believe, under the above scenario, P1 will be a better choice given the company’s assigned 2.6GHz spectrum is next to Digi’s, thus allowing for maximum benefit from the potential synergies from the combine spectrums in the future. Different mobile technology is not a concern in our view given that the current 4G technology is now able to merge the LTE-FDD and TDD network. We understand that capex required will be minimal if Digi combines its network with the LTE-TDD technology.

Pricing of P1. Korea-based SK Telecom had invested a total USD116.5m (or RM372.8m @RM3.20/USD) for a 25.8% stake in P1 since 2010, thus valuing P1 at RM1.4b. P1’s financial situation started to turn south since FY08, no thanks to the slower demand from the telecommunication companies, heavy promotional activities and higher subscribers' acquisition costs for its broadband business which has yet to reverse.

Based on Packet One Network (M’sia) S/D latest filing to SSM, the group’s revenue grew by 15.2% YoY to RM337.4m in FY12. Its bottom-line, however, continued to suffer losses, recording RM124.4m net loss in FY12; although the loss was significantly lower as compared to RM202.3m net loss in the prior year. The group’s reserve also continued to weaken and widen to –RM38.7m from –RM30.2m a year ago.

Network sharing/collaboration is more viable, in our view. While we believe P1’s spectrum is unlikely to come in at a cheap price, the smart partnership or network sharing will make more commercial sense to Digi, in our view, underpinned by the latest network technology which allowed a network operator to converge LTE-FDD and TDD networks. Meanwhile, Digi’s network vendor, ZTE, also have vast experience in the network convergence thus making the potential network collaboration, if any, more feasible. Based on our recent conversation with Digi’s management, capex is likely to be minimal if the group adopts the convergence LTE technology (given there are only few additional chipsets to be required) in the future. Nevertheless, management did highlight that they have yet to take any feasible study on the convergence LTE technology at this juncture.       

Update on LTE rollout. Both Maxis and Celcom have continued to expand their 4G-LTE services coverage since launching. Maxis’ 4G-LTE service has continued to gain traction with over 240k LTE subscribers recorded as at end-2Q13 (vs. c.130k in early June). The group’s 4G-LTE service has reached up to 10% population coverage nationwide (or c.33% population in Klang Valley) in 2Q13 from <2% in the end-March with plans to further expand its coverage to 20% by the end of this year. Meanwhile, Celcom was reportedly to have switched on around 70 4G sites since the introduction of commercial LTE services in the Klang Valley in April. We understand that Celcom aims to expand further to 1,200 base stations to cover 33 ‘strategic districts’ nationwide (or 30% population coverage) by end 2Q14. Digi, on the other hand, launched its LTE service in early July under the 2600MHz network and is available to all new and existing customers who subscribe to specific Digi’s Broadband and Tablet Plans.

We understand that Digi intends to roll out its LTE services to the small-screen market when the devices (that consist of the majority of LTE bands) are available in Malaysia's market. Capex-wise, we understand that Maxis has allocated RM500m for its 4G network upgrade and expansion over the next three years while Celcom and Digi planned to spend RM420m and RM600m (including 3G services) respectively in FY13.

MVNO landscape. The Malaysian mobile market has three main mobile network operators and a total of 11 mobile virtual network operators (“MVNO”), and still counting. Based on our understanding, Celcom has 5 MVNO agreements (with Merchantrade; Redtone Mobile; XOX Com; Smart Pinoy; and Tune Talk) while Maxis has 3 MVNO agreements (with U Mobile, Baraka Telecom and Salamfone) utilisting its network. Digi, meanwhile, has bagged 3 MVNO agreements (with Tron; Speakout Wireless; and Clixster) that riding on its network. We understand that most of the MVNO players in the country are not in active operations at this juncture.

MVNO player basically does not own the radio spectrum or wireless network infrastructure needed to provide their services. In fact, they sign agreements with carriers/telco to get bulk ingress to the network services (i.e. voice calls, SMS and data) at wholesale prices and resell to the MVNO’s respective customers at their own independent rates. Generally speaking, the MVNO concept usually targets the younger demographic or particular ethic group. For instance, XOX Com targets the young Chinese demographic while Salamfone targets the Muslims market in Malaysia.

Newbies in MVNO set to compete with big telco. Of late, Indonesia’s state-owned elecommunication giant, Telkom Indonesia, via its subsidiary PT Telekomunikasi Indonesia International (“Telin”) has entered into a MVNO agreement with Maxis. According to Telkom Indonesia, Telin has settled on a “pay-as-you-go'' model by paying 60% of its ARPU to Maxis for riding the

latter’s network. We understand that Telin will focus on the Indonesian community in Malaysia, including migrant workers, and recently launched its services in September. Similarly, Altel Communications S/B (formerly known as Puncak Semangat Technology S/B), which also operates on the MVNO model via a partnership with Celcom Axiata, was reportedly aiming to become a full-fledged telco once it has put in place its own infrastructure network to roll out its 4G broadband services. Altel reportedly is planning to spend RM1b on network infrastructure over five years, starting from December 2013, by building 500 LTE radio base stations in the first year and 2,100 in the next three years. We understand that Altel will provide voice services over the traditional 2G and 3G technologies (through partnership with Celcom) for the time-being but will focus more on 4G-LTE services and is aiming to provide voice services over LTE network once the country’s 4G landscape matures. No date of service availability was mentioned, Intensifying competition in the prepaid market. The aggregate of the total tier-1 local celco companies (i.e Maxis, Celcom Axiata, and Digi) subscribers’ net adds have continued to shrink for the two consecutive quarters. To a certain extent, we believe the drop was mainly led by the migration of the lower prepaid subscribers to U Mobile and other MVNO players. Going forward, the segment competition is expected to heat up in view of more muscular MVNO players (i.e. Telin & Altel) entering into the prepaid market, albeit the impact should be minimal during the initial stage.

Business Trust (BT) framework – the limelight for Digi in 4Q. The key event to watch out for Digi in 4QFY13 is definitely the upcoming BT framework where management has previously indicated the completion of the feasible study by end of this year. Based on our understanding, Digi is still exploring the best framework to house its assets and extract more cash from its free cash flow to further reward shareholders. At present, we understand that Digi has no intention to list the BT outside Malaysia should the framework materialised.

A trust is basically an arrangement whereby one person (a trustee) controls and manages assets on behalf of other persons (beneficiaries) who beneficially and economically own the assets and its income. A BT is much like a typical private trust, but unlike a normal unit trust which typically employs two operators (i.e. a trustee and separate manager), a registered BT has a single responsible entity – trustee manager. The trustee manager is both the trustee and the manager and holds the assets in the trust for beneficiaries and acts as a manager who is contractually authorised to manage the properties for these beneficiaries.

Digi’s BT listing may likely come in at a neutral impact. While Digi continues to remain silent on its BT feasibility study progress,the structure could turn to be a double-edged sword, in our view. The setting up of a BT would allow Digi to pay dividends from its operating cash flow, which is higher than its accounting profit due to depreciation charges, instead of accounting profit (where the group is currently restricted to distribute more than 100% dividend payout in view of its retained earnings limitation) and thus providing a positive catalyst to the share price.

The abovementioned positive catalyst impact, however, could be neutralised if Digi intends to raise more funds (from the BT listing) via offer for sale/placement as well as issuance of new shares in the future. While the move could potentially spark a special dividend (from the offer for sale/placement proceed) to the existing shareholders, it would also dilute the shareholders' interest as well as resulting in dividend cut (should the share dilution impact is higher than the dividend improvement) going forward, thus positioning Digi for a de-rating over the long term.

HSBB competition remains but manageable. The commercial launch of Astro-Maxis IPTV services since late April has yet to attract a meaningful signup thus far. Astro recently announced that its IPTV service only gained ~3k subscriber's net adds as of end-July despite the group claiming 10,000 households registering interests during the first two weeks of the product launching. We understand that the key drawbacks are due to the installation inefficiencies (given the the installation process involves three parties - Astro, Maxis and TM) and the lack of service assurance. Astro indicated that the installation turnaround time of its IPTV is improving and is confident to achieve higher take-up rate going forward.

On TM front, to remain competitive in the HSBB segment, the group has introduced several ‘value for money’ packages in its HyppTV service since late April. TM’s Unifi has added 45k new users, bringing its total subscribers to 577k in 2Q13. Its blended Unifi’s ARPU, meanwhile, also increased to RM180 in 2Q13 (from RM178 in the preceding quarter) thus signalling an encouraging take-up in its higher-end packages as well as value-added services. Despite the intensifying competition, the group’s Unifi subscribers have continued to grow to more than 600k in mid-September, which implied a take-up rate of c.42%. Going forward, we believe TM’s Unifi will continue to gain traction during the rising cost environment as a cheaper alternative triple play service in contrast to the Astro-Maxis IPTV service, at generally c.20% lower price under the same broadband speed. We reiterate our view that the country’s HSBB market is big enough to occupy two key players.

Source: Kenanga