We downgrade our rating on the telecom sector to UNDERWEIGHT (from Neutral) due to heightening risk of valuations becoming stretched at this juncture amid rising bond yields. Nonetheless, we believe fundamentals for the sector should remain intact. After revising our DCF assumptions, we downgrade DiGi and Maxis to SELL but retain our NEUTRAL call on Axiata and TM.  

- Downgrade sector to UNDERWEIGHT. We downgrade our rating on the telecom sector to UNDERWEIGHT (from Neutral) due to heightening risk of valuations becoming stretched at this juncture. This is premised on higher WACC for the stocks under our coverage, after we raised our assumptions for the risk-free rate and equity risk premium, which subsequently led to downgrades in  DiGi (SELL, FV: MYR4.10) and Maxis (SELL, FV: MYR5.90).  We have revised lower our FVs for  Axiata (NEUTRAL, FV: MYR6.60) and  TM (NEUTRAL, FV: MYR 5.30.  We have downgraded Time dotCom (NEUTRAL, FV: MYR3.80) following its recent share price run up.

- Valuations not cheap. Valuations for the stocks under our coverage are quite stretched, hovering at one to two standard deviations (SD) above their 3-year average forward P/Es. This implies some vulnerability but we think there is still some degree of defensiveness left as telecom stocks usually have well-articulated dividend policies and are index-linked, which offer unexciting but steady earnings growth.  

- Fundamentals should remain intact. While the telecom sector generally still offers above-average dividend yields relative to other sectors, we think valuations may potentially face downward pressure should bond yields continue to expand. Higher bond yields would translate into a higher risk-free rate, against which our DCF valuations are benchmarked, thus leading to lower valuations. However, we believe the sector’s fundamentals still remain sound.

- Rise in bond yields a risk to valuations. The lower FVs for the stocks under our coverage are based on the assumptions that: i) risk-free rate rises by 1.0ppt to 4.5%, and ii) equity risk premium rises by 1.0ppt to 1.5ppt, depending on stock-specific  valuation levels (the quantum is higher for stocks with higher valuations). We have left our earnings forecasts unchanged.  We believe our risk-free rate assumption is fairly reasonable given that the 10-year Malaysia Government Security (MGS) yield has shot up by 70bps to 3.75% from a low of 3.05% in mid-May.

Source: RHB