We are downgrading our telecommunication sector to NEUTRAL in view of the limited potential upside of 4.7% based on targeting sector market capitalization. Mobile segment competition is expected to intensify with TM-P1 set to launch its LTE mobile services in 1H16. Meanwhile, the foreign workers prepaid market also appears crowded with incumbents likely to introduce more intra-ASEAN communication services. On the flip side, broadband demand is set to surge further following the recent signing of TM’s HSBB2 and SUBB projects with the authority. We believe broadband penetration, network coverage/quality, forex and competition will remain as game factors for the year 2016. Valuation-wise, we make no changes to all our telco companies’ FY15-FY16 earnings estimate. We reiterate our OUTPERFORM call on TM (TP: RM7.33) and Axiata (TP: RM6.92) while keeping our MARKET PERFORM call on Maxis (TP: RM6.48). Digi, meanwhile, had its rating downgraded to MARKET PERFORM with a lower target price of RM5.60. TM remains our favourite pick for the sector given: (i) the less competition in its fixed-line broadband business, and (ii) potential better-than-expected synergies from P1.

No major excitements. The sector incumbents’ 3QCY15 report cards were generally below expectations, with fixed-line operators being the only players which met forecasts. Having said that, mobile incumbents’ aggregate service revenue managed to show some traction and grew 1.3% QoQ in 3Q15, mainly underpinned by Maxis as a result of its continued uptrend in prepaid and stable postpaid revenue. However, all the cellcos were hit by higher operating costs during the quarter, no thanks to the higher IDD interconnect charges (due to unfavorable forex rate) as well as data pricing competition that dampened margins. ARPU-wise, both Digi and Celcom’s blended ARPUs remained the same in 3Q15 while Maxis recorded a RM2 uplift to RM53 following the continued strong traction gained in the MaxisOne plan. TM’s EBITDA margin, meanwhile, managed to sustain at 32.6% despite P1 continuing to post losses.

Competition remains intensifying. Competitions among the mobile incumbents are expected to persist in the 1H16 given that Celcom intends to focus on customers’ acquisition over the next 1-2 quarters. Besides U Mobile posing an increasing threat to the big three players, TM-P1 is set to launch its LTE mobile services in 1H16, which could provide a credible threat to the incumbents in view of the former valuable spectrum assets (850Mhz, 2.3Ghz and 2.6Ghz) and potential leverage on TM extensive network. In the fixed segment, while TM’s broadband demand continued to remain healthy, it has grown at a much slower pace, thus suggesting that low-hanging fruits have diminished under the HSBB1 plan.

Challenges persist in the foreign workers’ prepaid market. U Mobile and Telin Malaysia (a subsidiary of PT Telkom Indonesia) have introduced a first of its kind 2-in-1 SIM card in September for seamless cross border communication for making affordable IDD calls at local rates. On top of that, the recently proposed acquisition by Axiata to acquire Ncell, the number-one mobile operator in Nepal (where the country has more than 3m overseas foreign workers of which c.1m are in Malaysia), could allow the former to further leverage its services (i.e. intra-ASEAN international calling and mobile remittance and etc.) across the region.

Higher broadband demand ahead. The recent signing of TM’s High-Speed Broadband 2 (HSBB2) and Sub-Urban Broadband (SUBB) projects with the government is expected to widen the country’s broadband penetration (from 28.4% DEL penetration rate as of end 2Q15). HSBB2 will be rolled out over a period of 10-year with the authority investing RM500m and TM RM1.3b to provide high-speed broadband access to over 390k premises by 2017. SUBB, meanwhile, will be rolled over a period of 10-year and cost RM1.6b (of which the government will bear RM600m) to provide broadband access to over 420k premises by 2019. With vast network experience coupled with encouraging requests received outside the HSBB1 areas, we believe TM should be able to shorten the gestation periods when it rolls out HSBB2 and SUBB.

Opportunities and risks in 2016. We believe broadband penetration, network coverage/quality, forex and competition will remain as the game factors for 2016. While prices offered by telcos are already at a very competitive level, the key differentiating factors are likely to come from the value-added services and consumer experience. The internet of things (IoT) and big data analytics, meanwhile, are expected to get more acceptances and drive the data demand moving forward. All these suggested that the incumbents need to continue their hefty capex plan to maintain competitiveness. Besides, potential change in regulatory landscape (i.e. TPP, and spectrum reframing) and irrational pricing schemes will continue to be the key risks for the incumbents.

Lower our optimism on Digi. Despite Digi having higher operational efficiency and better competency in monetising data against its peers, the heightened competition in the foreign workers’ prepaid market may pose a credible threat to the group which has a lion's share in the foreign worker community in Malaysia. We make no change to our Digi FY15-16 earnings’ estimates. Nevertheless, in view of the heightened competition ahead in the foreign workers’ prepaid market, we have downgraded our Digi rating to MARKET PERFORM with a lower target price of RM5.60 (from RM6.05 previously), based on a lower targeted FY16E EV/forward EBITDA of 13.3x (vs. 14.4x previously), representing a 0.5x standard deviation above its 4-year mean.

Source: Kenanga Research - 7 Jan 2016