We upgrade our telecommunication sector call to NEUTRAL (from UNDERWEIGHT previously) as; (i) the incumbents’ share prices are providing limited downside after the recent sell-down, (ii) foreign shareholdings reduction could be at the tail-end, and (iii) benefit from index weighting (due to its large cap, liquid & Shariah compliance sector status) despite the sector’s earnings expected to remain muted. We believe network coverage/quality, forex, spectrum and competition will remain as the key factors for the local telecommunication sector in 2017. We make no changes to all our telecom companies’ FY16-FY17 earnings estimates. We continue to favour fixed-line over the mobile names under the current challenging time given that the latter’s earnings are set to be affected by the heightened competition. On top of that, the upcoming spectrum re-farming exercise is also expected to change the mobile landscaping in the long-term. Telekom Malaysia (“TM”, OP, TP: RM6.98) remains as our favourite pick for the big cap while OCK (OP, TP: RM0.96) is maintained as our preferred choice under the mid-cap telecom space. Meanwhile, we have also changed all our mobile players’ ratings to MARKET PERFORM in view of the limited share price fluctuation from here. All in all, we believe the sector is likely to trade side-way while waiting for new catalysts to emerge. Digi (TP: RM4.79) would be the better choice for consistency play (supported by its agile execution capability and high dividend yield of >4%) while Axiata (TP: RM4.81) remains a better pick for a rebound theme.

2017 outlook. We believe network coverage/quality, forex, spectrum and competition will remain as the key factors for the local telecommunication sector in 2017. While prices offered by telcos are already at very competitive levels, the key differentiating factors are likely to come from the consumer experience (as a reflection of the network coverage/quality) and value-added services. Forex, meanwhile, is expected to remain volatile, which could affect players’ capex plan and IDD business if MYR continues to weaken against the USD. Besides, competitions among the mobile incumbents are expected to persist in 2017 with data-centric offerings remaining as the key theme for 1H17 followed by the network quality premise (note that, both Digi and UMobile will have a similar playing field with Celcom and Maxis after the recent concluded 900MHz & 1800MHz spectrums reallocation plan, which takes place from 1 July 2017). We believe Maxis may face a great challenge in 2017 in view of its extensive gap in its subscription plans offered where its MaxisONE plan is priced at more than 23% premium against the peers.

Spectrum re-farming 2.0. MCMC is keeping no secret of its intention to further optimise the usage of other relevant spectrum bands such as the 700MHz (upon completion of the digitalization and migration of current broadcast operators), 2300MHz, and 2600MHz (which licenses are due for renewal in CY17) in coming months. Spectrum pricing wise, while we believe the price tag is unlikely to be economical, the authority is likely to adopt a similar system (akin to the previous spectrum re-farming plan) where payments will be made in phases and with operators allowed to roll out services without passing along the cost to consumers.

Muted earnings outlook. We expect the aggregate mobile players’ PATAMI to be weakened by 2% YoY in 2017 as a result of the uninspiring service revenue growth (due to heightened competition and lack of effective data monetisation plan), high depreciation (due to rapid 4G network expansion) and finance expenses. TM’s earnings, meanwhile, is expected to grow by c.6% YoY in FY17, mainly underpinned by higher broadband demand and normalised tax rate (c.30% vs. 38% in FY16).

Strategy – still prefer fixed-line players overall. TM (OP, TP: RM6.98) remains as our favourite big cap pick for the sector given: (i) less competition in its fixed-line broadband business, and (ii) its inroad to become a convergence champion. Besides, we also believe the recent sell-down led by higher internet speed mandate has been overplayed. OCK (OP, TP: RM0.96), on the other hand, remains our top picks for the mid-cap telecom in view of: (i) its healthy cash flow on the back of escalating recurring income trend, (ii) its ability to ride with the passive infrastructure sharing trend, and (iii) its expanding EBITDA margin trend. We continue to downplay the mobile names due to their uninspiring outlook. Despite maintaining our target prices for both Maxis (TP: RM5.80) and Digi (TP: RM4.79), their ratings have been upgraded to MARKET PERFORM (from UNDERPERFORM previously) in view of the limited downside from here. Our AXIATA’s target price, on the other hand, remains at RM4.81 but with a lower rating of MARKET PERFORM (vs. OUTPERFORM previously) as the share price has rebounded from its low recently, thus providing limited upside from here.

Despite the sector incumbents’ 3QCY16 results largely within expectations, we have trimmed most of our earnings forecasts lower in view of the challenges ahead. Maxis and Digi appeared to have delivered relatively solid set of results (after several earnings revisions in 1H16) in 3Q16 while Axiata continued to be impacted by the sub-optimal performance at its key OpCos. TM’s earnings, meanwhile, came in largely within expectation but the persistently high OPEX had led us to reduce earnings forecasts post results review. The sector’s top three mobile incumbents’ aggregate service revenue, meanwhile, contracted by 4.7% YoY to RM5.2b in 3Q16, no thanks to the heightened price & data quota-centric competition and the poor Celcom performance (as a result of heightened competition, particularly in the overseas foreign workers' segment). On a QoQ basis, the aggregate service revenue has improved by 1.4% as a result of higher Maxis performance (thanks to stronger Prepaid segment performance) and moderate Celcom performance (low-base effect) but partially offset by lower Digi contribution (as a result of weaker Prepaid performance).

Spectrums landscape. The country’s telecommunication spectrum landscaping has changed partially post the first round of the spectrums (900MHz and 1800MHz) re-farming exercise (figure 1). The new landscaping, however, is not expected to be decided from here given the authority’s intention to optimise usage of other relevant spectrum bands such as the 700MHz, 2300MHz, 2600MHz and etc. in coming months. All the Cellos have shown their interest for the remaining spectrum bands, especially the 700MHz due to its wider coverage (which implied lower capex) and better indoor strength signal. At present, the 700MHz spectrum or frequency is used by broadcasting services, which would be able to free up a sizeable digital dividend (at frequency bands of the 698-806MHz band) after the country switches over from analogue to digital TV in mid- 2018. Propagation characteristics of the 700MHz band will facilitate improvements in the mobile coverage, especially in the rural areas, as well as to provide better indoor coverage in more densely-populated areas. Note that, the World Radio-communication Conference 2015 (WRC-15) has identified spectrum in the 694-894 MHz frequency band to facilitate mobile broadband communications. As for the 2300MHz band (a total of the 90MHz band), the frequencies are mainly used for deploying the 4G WiMAX services, where the spectrums have been allocated to three companies – namely Webe, Redtone and YTL Communication in a year 2007. On the other hand, the blocks of the 2600MHz spectrum which are assigned for LTE services, have been assigned to eight telecom companies in late 2012 by the authorities. All in all, we expect the government to re-farm the above-mentioned spectrums in a fairer approach and a more equitable manner to encourage healthier competition moving forward.

Foreign shareholdings have returned to the pre-massive dividend distribution period. The weakening of MYR (against the USD) coupled with an uninspiring earnings growth prospect as well as the change in the industry landscaping followed by the spectrum re-farming exercise have led to foreigners downplaying Malaysia telecommunication sector. Indeed, foreign funds have reduced their holdings to the early of CY11-level or pre-massive dividend distribution period (figure 4). Note that, Malaysian telecom operators have distributed handsome dividends (in a form of special dividends/capital repayment) to reward shareholders during CY12-CY14. Thus, as the earlier escalating foreign funds participation could to a larger extend was enticed by extraordinary dividends payment, the recent foreign shareholding reduction (to early CY11-level) could be suggesting that the sell down may likely be at the tail-end. On top of that, the sector, being the large cap, liquid & Shariah compliant sector, could benefit from its index weighting and provide a steady support to share price performance moving forward.

Risks factors. Irrational price competition, additional capital outlay to hold spectrums and limited growth prospect (as a result of a persistent weak consumer sentiment) remain the key risk factors for all Cellcos. Apart from that, other key risk factors are; (i) Digi – prolonged price war may (continues to hamper immediate growth, (ii) Axiata – regulation and currency risks in its overseas venture while upside may come from stronger-than-expected operational performance in Celcom & XL, and (iii) Maxis – higher-than-expected subscribers’ churn and positive dividend surprises. For TM, key upsides are positive earnings and/or dividend surprises while larger-than-expected Webe losses and intense competition on its Internet segment remain its key downside risks. For OCK, its key downside risks include project risks, dependence on directors, key personnel, major customers/contracts, as well as foreign-currency risk while upside may likely come from better-than-expected project margins.

Source: Kenanga Research - 6 Jan 2017