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The Australian mobile market is about to undergo its biggest shakeout in years and, rather than wait for change to be thrust upon them, mobile incumbents are acting pre-emptively to ward off a new and unexpected foe.
TPG Telecom is about to enter the mobile market and the price war has already begun.
Prices in the mobile telecoms market have fallen even as data and call inclusions have ballooned. The impact was clear following the recent round of results.
Telstra reported lower average revenue per user (ARPU) for the first time in years and, although customer growth was healthy, more data inclusions have meant losing hundreds of millions in revenue earned from fees for exceeding data caps.
Telstra isn’t alone in feeling the pinch. ARPU at amaysim and Optus are both falling and, while Vodafone reported stable ARPU, it is from a lower base and reflects recovery following years of customer losses.
Aggressive discounting and a race for market share are predictable responses to a new market entrant but TPG is hardly a typical challenger.
It has announced it will spend just $600m on a new domestic network – far less than the incumbents spend on annual network maintenance – and has a modest target to reach just 80% of the population against 96% plus from its peers.
For a business with a reputation for cut-price aggression, these are unremarkable aspirations and has industry insiders asking how TPG can build a credible network that covers fewer people in fewer places.
Most have dismissed the wannabe as a minor force but, with new information about TPG’s plans recently made available, we think it will be far more disruptive than anyone expects and it’s time to start factoring in the waves this upstart will make.
In preview, while we don't want to jump at shadows, we're more uncertain about where we'd be willing to buy amaysim and Telstra. As a result, while we're happy with our Hold recommendations, we're removing price guides from both of them for the time being. In amaysim's case, we expect to reinstate a guide following its final result in August, which we hope will provide some clarity about how its cross-selling model is working. With Telstra, we're aiming to have a guide back sooner, following further analysis.
In our hunt for a clearer understanding of the sector, the first question we need to ask is what's TPG up to? Several mobile competitors have tried to disrupt the status quo and all have failed. Will TPG’s attempt be any different?
When small packets grow
Ten years ago, I paid $10 a month to keep my Sony Ericcson mobile phone running, whereas today I spend $50 a month for access to my iPhone. For once, my own experience reflects a wider one.
Everyone pays more for mobiles than they did a decade ago but everyone also uses their phone in wider and stranger ways than before. We used to send and receive small packets of data to support mostly voice calls; now we're dealing in packets several magnitudes larger, streaming video, music and browse content rich media. Voice is often a secondary consideration – if it's even a consideration at all.
Modern mobile networks have evolved to support these new uses. When the Hutchinson-backed 3 first tried to disrupt the Australian mobile market it bought high-frequency spectrum because that was what was available. It promised a data-rich user experience because that’s what everyone expected, but struggled to deliver it because the high-frequency spectrum failed to penetrate walls in cities and couldn’t navigate dense environments.
To counter this deficiency, 3 had to build a higher density network than its peers and, because the service was terrible, it was never able to fill that network with users. It was eventually taken over by.
Vodafone. 3 is the cautionary tale and the most common one told to dismiss the TPG threat. This time, however, is different.
Operators now know that users send dense data packets over the network and the best transport for those packets is low-frequency spectrum. Luckily, there is a bit of spare spectrum to go around. The move from analogue TV signals to digital has freed up limited low-frequency capacity and was greedily gobbled up by TPG and Vodafone at auction last year. Telstra still has the most low-frequency capacity but TPG doesn’t fare too badly.
Networks are now also built to handle an entirely different form of traffic. 3G networks were touted as ‘next generation’ and internet-enabled but these were essentially voice-dominated networks with some data capability.
All that changed with 4G. Here was a network that eschewed old-fashioned voice networks and was built to handle rich seams of data. 4G is why Facebook is brainwashing your child and why you can watch House of Cards on the train.
The data shows we’ve been taking advantage of 4G's capabilities. Data consumption has exploded since the introduction of 4G mobility with inclusions from the average mobile plan rising from 1.7GB in 2013 to 7.5GB now.
Past disruptors like 3 and Onetel were always destined to fail because they lacked bandwidth and fibre to support their networks. TPG has the right building blocks. It has high-quality spectrum and, just as important, it has a dense array of backhaul. It is here that TPG makes the best case for the success of its network.
Backhaul refers to the extensive fibre infrastructure that supports data on a mobile network. A spaghetti field of fibre goes from tower sites to exchanges and data centres to make modern mobile networks possible.
TPG already has one of the most extensive metropolitan fibre networks in the country to distribute broadband. By linking this to mobile towers utilising the latest in small cell technology, it can reduce costs, extend range and minimise congestion. Although it is ‘only’ spending $600m on its network, much of the work has already been done and new technology means less needs to be done.
TPG’s greatest advantage, however, may be cost.
TPG’s network will be nothing like Optus or Telstra which reach about 98% of the population. Replicating such deep penetration to service limited customer numbers would be a waste when the population centres in Australia are all in a handful of cities.
TPG must make roaming agreements with a carrier to provide regional access – Vodfaone is a logical partner – but its network will aim to serve densely populated urban centres.
This strategy will generate a different set of economics to peers. Since it will have lower capital expenditure, lower operating costs and higher network utilisation, it should be profitable at a lower revenue base which means prices can afford to be a lot lower.
Rob Miller, the Chairman of Soul Patts recently let slip that TPG may target ARPU at $15 per month. That's about half our earlier estimates and suggests that TPG may reach cash flow break even with 500,000 customers and just $90m in revenue. With 3m customers, it could generate over $500m in revenue and $160m in earnings before interest, tax, depreciation and amortisation (EBITDA).
In NBN’s shadow
An aggressively priced metropolitan network is unlikely to be the sole design of TPG. As it would share fibre for broadband and mobile backhaul, TPG could use its mobile network as an NBN fighter, offering mobile broadband plans at higher margin than the NBN.
It's conceivable that the mobile strategy is being pursued to lift broadband margins and fight the NBN as much as it is to generate mobile profits and fight incumbents.
By building a limited network at low cost, TPG should be able to generate substantial broadband revenues and use mobile revenues as a customer acquisition tool or to raise network utilisation.
These are only guesses, but it's clear that TPG is doing something different from its peers and we shouldn’t expect the same strategy or the same result.
We confess we have no idea what TPG is doing in Singapore but we do know that it has launched aggressively. TPG Singapore is offering free mobile services with 3GB of data for 24 months to anyone over 65. Targeting low churn older populations might or might not work, but it shows that TPG will be a genuine – and terrifying – disruptor when it launches here.
Impacts on incumbents
This has implications for mobile incumbents and low price, low-margin businesses will be first in the firing line.
Things could go two ways for amaysim. A price war generally increases customer acquisition costs, which might support the value of its bank of 1.1m customers, but lower prices would also reduce the revenues to be earned from them, thereby reducing their value.
We don’t know which way this will go but expectations of stable or recovering ARPUs should be abandoned. TPG will force prices lower than many expect.
Only half of amaysim's business is now mobile so a lot will depend on energy and its cross-selling strategy. With the share price already savaged and valuations far from stretched, we recommend patience because success with this strategy could generate significant upside.
Fighting TPG, however, would be a difficult task for a reseller and a hyper-aggressive strategy from TPG would raise risks for amaysim. Due to uncertainty around its cross-selling strategy and the difficulty in estimating ARPU ahead of TPG’s mobile launch, we're removing our price guide for the time being, but continue to recommend that you HOLD.
Telstra is a more difficult case. It has infrastructure advantages that even TPG cannot replicate and is arguably the best mobile operator in the world. High margins, however, are a prize to lose; we expect lower prices to eventually translate to lower margin.
That, however, is largely reflected in the price. The scary part about Telstra is its ambition. It aims to offset broadband and mobile margin decline with a plan to become a global technology business. For a domestic telco, these are lofty dreams and pose significant risks. While the valuation is appealing, the strategy is not. We're removing the price guide pending further analysis, but recommend that you HOLD.
As for TPG itself, this could be a masterstroke or a disaster, but it's certainly ambitious. The challenger is doing things differently from the pack and we think a closer integration between broadband and mobile assets will be likely, driving mobile prices lower than many expect.
After consulting with competitors and industry insiders, we're comfortable with TPG’s strategy but repeat that this will require patience and gumption. TPG is fighting a guerrilla war and there is a long way to go yet. BUY.
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