We are maintaining our NEUTRAL call for the telecommunication sector. The sector FY14 PER is expected to face some downwards pressure based on our dividend payout and risk-free rate studies. These studies also showed that Maxis’ FY14 PER is expected to contract while PERs for both Telekom Malaysia (TM) and Axiata are likely to be inflated. However, for Digi, its PER direction in FY14 seems to be mixed. While the data segment remained as the key focus for all celcos, strategies of celcos will likely focus on spurring smartphone penetration rate through entry-level smartphone as well as widening network coverage in FY14. There is no change in our telecommunication companies’ FY14-FY15 earnings forecast. Our 1Q14 stock pick, TM has advanced by 10.1% YTD (as of 25 March 2014), outperforming the sector (-0.1%) and FBMKLCI (-1.0%) for the same period. In view of TM’s current share price which is trading above our target price, we downgraded the stock rating to MARKET PERFORM from OUTPERFORM. Despite the lower stock rating, TM (TP: RM6.00) remains our top pick for the sector due to 1) its solid presence in the FTTH market; 2) milder competition in its wholesale and fixed-line segments; and 3) potential bagged the HSBB 2 project, which could lead the company to use the prospective saving in capex (or government grant) to reward its shareholders. If we were to assume TM bagged the project, we estimate that the government grant could come in at between 20%-25% range (or RM360m-RM450m representing 10.0 – 12.6 sen per share), a similar quantum that the company received in Phase 1 of the HSBB project. Meanwhile, Digi’s stock rating is also lowered to MARKET PERFORM after it advanced by 8.1% YTD and is now trading slightly above our target price of RM5.24. There is no change in our MARKET PERFORM call on both Maxis (TP: RM7.10) and Axiata (TP: RM6.57). We reiterate our OUTPERFORM call on small cap telco player, Redtone, with an unchanged target price of RM0.81.

4QCY14 result's snapshot. All the local telecom players posted results that came in within expectations except for two outperformers, TM and Digi. The former was mainly due to a tax incentive while the latter was fueled by stronger uptake of its mobile Internet services and better cost efficiencies. Axiata’s short-term outlook remains challenging due to the XL-Axis integration costs and continued currencies' fluctuations in all its key regional operations. Maxis, on the other hand, continued to be lacklustre as expected, due to its on-going business transformation plan.

Telco sector’s PER has a strong correlation with dividend payout rather than the risk-free rate. Based on our consensus dividend payout and yield spread studies, the sector’s PER has a stronger correlation of 93% with the dividend payout in contrast to -58% correlation with MGS 10-year yield. Our finding also showed that the sector’s PER is likely to be narrowed in FY14. On company specific, Maxis’ FY14 PER is expected to be narrow while both TM and Axiata’s PER are likely to widen. Digi’s PER direction in FY14 is seen to be mixed.

Focus on entry-level smartphones to spur penetration rate. The recent conclusion of the Mobile World Congress (MWC) in Barcelona, Spain, suggested that majority of phone vendors are focusing on introducing entry-level rather than higher-end smartphone in 2014. To further improve the celcos smartphone penetration rate; we believe the local celcos would introduce more entry-level data plans in the near-term to spur data usage. As of end-FY13, the smartphone penetration rates for Maxis, Celcom and Digi stood at 56%, 38% and 38.1%, respectively, which suggest rooms for growth in the future.

FY14 earnings guidance suggested that the sector is reaching a temporary maturity stage where players are only expecting organic top-line growth (or 4%-5% YoY) given that voice and SMS revenue have declined while the data segment has yet to show a strong growth. Capexwise, all telcos are guiding capex to pick up this year with an aim to expand network coverage and capacity improvement. LTE rollout is also another key investment area.

Competition in the fibre-to-the-home (FTTH) segment may likely ease following the review of its Home segment by Maxis. No decision has been made by Maxis thus far, but we believe the group will likely scale-back rather than terminate the segment services given the high contract obligations. Note that, Maxis has started to provide RM65m provision for its contract obligations of Home services’ network and content costs in 4Q13. We believe, TM will be the key winner under this scenario should Maxis decide to scale back Home services’ segment.

Source: Kenanga