3Q14 results were in line. Management expects growth to be challenged by  steepening  competition  but  believes  Digi  remains  well  positioned with  a  brand  new  billing  system  complementing  its  modernised network. We continue to like Digi  for its superior data revenue growth, strong prepaid  value proposition and execution track record. Maintain BUY, with a new DCF-based TP of MYR6.60 (11.3% upside). 

No  surprises.  At  74%  of  our  and  76%  of  consensus  core  earnings, Digi.Com (Digi)’s  9M14 results were in line.  Revenue grew 3.3% YoY  in 3Q14  (+0.6% QoQ)  and  4.4% YTD,  at  the lower end of its 4-6%  FY14 revenue  guidance  –  albeit  with  the  benefit  of  a  seasonally  stronger December  quarter from new handset launches.  The lower  effective tax rate  in  3Q13  (16.7%)  moderated  net  profit  growth  to  9%  YoY  in  3Q14 (YTD: +27.1% YoY) vs 39.5% in 1HFY14. An expected third interim DPS of 6.2sen/share  (99% payout  ratio) was declared,  bringing total DPS to 18.8sen/share.  

“Internet  for  All”  drives  solid  data  traction.  Digi  has  made  further inroads  into  the  prepaid  data  market,  supported  by  a  combination  of affordably priced smartphones and  attractive  data bundles. As a result, smartphone penetration accelerated to 47% in 3Q14 from 42% in 2Q14, closing  in  on  Maxis  (MAXIS  MK,  NEUTRAL,  TP:  MYR6.50),which  has the highest  base of smartphone users. Its data revenue growth of 17.9% YoY in 3Q14 more than offset the erosion in voice (-6.2% YoY) and SMS (-19.1% YoY), contributing to the 2.1% service revenue growth.   Outlook. Management expects growth opportunities to be challenged by competition  but  believes  Digi  is  well-positioned  to  compete  with  a modernised network and state of the art billing platform. 

Forecast. Digi has reaffirmed its FY14 revenue growth guidance of 4-6% and  an  EBITDA  margin  similar  to  FY13’s.  We  leave  our  FY14/15 forecasts  unchanged  but  lift  our  FY16F  EPS  to  factor  in  the  1pptreduction in  the  corporate tax rate. Note that  we have not reflected the GST impact  into our forecasts,  to err on the conservative  side. Key risks to earnings are higher-than-expected competition and capex.

Highlights from 3Q14 results call 

Digi held  its regular  quarterly  investor call following the release of its 3Q14 results. The  session  was  hosted  by  its  CEO,  Mr  Lars  Ake-Norling  and  CFO,  Mr  Karl  Erik Broten. The key queries centred on:  i)  the mobile competitive landscape,  ii)  its new converged billing system and iii) the impact of the GST. Rising  competitive  intensity.  Management  acknowledged  that  competition  is heating  up,  with  operators  having  to  contend  with  a  decline  in  service  revenue (1HFY14:  -1% YoY).  To sustain its growth momentum, Digi  would continue  to drive data  monetisation  opportunities  via  more  relevant  product  offerings,  smartphone bundles  and  targeted  channel  activities.  We  believe  Digi’s  data  revenue  growthcontinued  to  outperform  the  industry  (3Q14:  +17.6%  YoY),  translating  into  further gains  in  data  revenue  share  (see  Figures  2  and  3)  during  the  quarter.  The  robust growth  was  against  a  backdrop  of  an  increasingly  aggressive  U  Mobile,  IT  issues plaguing Celcom  and  Maxis’ focus on  bolstering its  postpaid segment.  While Digi’s short  messaging  service  (SMS)  revenues  have  not  been  spared  by  the cannibalisation from over-the-top (OTT) applications,  we note  the magnitude of the decline has trailed its rivals,  which could be attributed to its smaller postpaid revenue contribution.

Digi  is  on  track  to  achieve  the  target  of  3G  population  coverage  of  86%  by  end December  (3Q14:  84%).  It,  however,  refrained  from  disclosing  the  number  of  LTE sites, citing competitive reasons (earlier target of 1,500 by end-2014).

Billing platform  upgrade.  Digi successfully migrated its postpaid customers to the new  converged  billing  platform  in  August,  followed  by  prepaid  subscribers  in September.  We think the upgrade of its billing system is timely coming on  the heels of  its  vastly  modernised  network,  allowing  the  telco  to  launch  more  innovative products  and  services  and  improve  upon  its  time  to  market.  A  key  feature  of  the system is the ability to execute dynamic charging based on real-time intelligence.

A more guarded view on GST. Digi  appears cautiously optimistic on the  impending implementation  of  the  goods  and  services  tax  (GST)  come  1  April.  This  is unsurprising  as consumers are bracing for  additional  hikes in the prices of essentialgoods,  with  a  further  dial-back  of  fuel  subsidy  next  year  impacting  consumption propensity.  While the  industry  no longer needs to absorb the current 6% sales tax levied  on  prepaid  services,  we  think  the  telcos  may  exercise  some  discretion  in passing on the tax to factor in possible cuts in usage and  voucher reloads among the more price-sensitive customers –  which also comprise migrant workers. We estimate that  the  GST will boost Digi’s earnings by  6-9% for FY15/16,  assuming  it no longer absorbs the tax and there is no change in subscriber behavior.

Regulatory update. Management  said  it is awaiting  a  decision  from the Malaysian Communications and Multimedia Commission (MCMC) on the  upcoming re-farming of the 900/1,800MHz spectrum. Not surprisingly, there has been no further update on the business trust (BT) structure.

Key Risks
Higher-than-expected competition and capex are the key earnings risks for Digi.

Forecasts
Digi has reaffirmed its FY14 revenue growth guidance of 4-6% and EBITDA margin similar to that of FY13. We leave our FY14/15 forecasts unchanged but nudge up our FY16F  EPS  to factor in the 1ppt  reduction in corporate tax rate. Note that we have not reflected the GST  impact  into  our forecasts to err on  the conservative and our belief is  that the  eventual earnings impact from the implementation could be dilutedsomewhat.  Digi’s  capex  of  MYR671m  YTD  is  in  line  with  its  full-year  guidance  of MYR900m and our expectation.

Valuation & Recommendation 
Maintain BUY. We continue to like Digi for its superior data revenue growth, strong prepaid value proposition and execution track record. While the GST impact remains uncertain,  Digi  stands  to  be  the  strongest  beneficiary  in  the  event  of  a  full  passthrough  as it  has  the  highest  prepaid  revenue  contribut ion  among  its  peers  at  an estimated  65%.  We  have  replaced  our  dividend  discount  model  (DDM)  valuation methodology  with  that  of  DCF  (WACC:  7.1%,  TG:  3%)  which,  in  our  view,  better captures  the  telco’s  longer-term  growth  prospects  and  operational  improvements. Our revised DCF-derived TP is MYR6.60 (vs  a  DDM-based  TP of MYR6.50),  which offers a more than 10% upside. Digi remains our top telco pick in Malaysia.

Source: RHB