Telstra Corporation: Smart structure makes Digicel risk/reward compelling

About the author:

Nick Harris
Author name:
By Nick Harris
Job title:
Senior Analyst
Date posted:
26 October 2021, 9:30 AM
Sectors Covered:
Telecommunications, Technology

  • Telstra Corporation (ASX:TLS) will acquire 100% of PNG mobile operator Digicel. Given ongoing media speculation, this deal isn’t a surprise. However, the financial structure is smarter than we had anticipated. TLS is effectively guaranteed a six-year payback on its US$270m equity contribution with the Australian Government insuring the risks.
  • Digicel will operate as is, with plans to keep management and TLS having Board control. It will be placed under TLS’s international business unit.
  • We forecast ~3.5% EPS accretion and ~7% FCF per share accretion for the first 6 years (under protected status). Then payments to government equity kick in. The net result is our target price increases (login to view), Add retained.

Event

Telstra Corporation (ASX:TLS) (and the Australian Government) will pay ~6.5x EBITDA (upfront). TLS owns 100% of the equity and has priority status with a ~6-year payback largely underwritten by the Australian government; which contributes minority equity and debt funding. In addition, the earnout, if achieved, is 20% paid by TLS, 80% Govt.

The Digicel business is being acquired on a ~10% FCF/ upfront Purchase Price.

TLS contributes US$270m of equity while the Australian government contributes US$1.3bn. The government’s US$1.3bn contribution is roughly 55% debt and 45% “equity like security”.

EBITDA of ~US$230m has been very resilient, growing yoy for the last two years. FCF has averaged US$166m over the last three years. Capex at ~15% sales and spectrum licenses were just renewed for 15 years.

The deal is expected to settle in the next 3-6 months. We assume 1 July 2022.

About Digicel

Digicel operates in 6 countries and is #1 (by subscribers) in 5 of those 6 countries.

PNG accounts for ~80% of EBITDA. Digicel PNG has ~55% 4G population coverage (964 mobile sites – of which 146 are only accessible by helicopter).

The revenue split is 76% mobile services; 13% business solutions; and 7% TV and Broadband.

PNG mobile penetration is just 30%. Earnings growth should come from greater 4G coverage and a higher per person take-up. There are no material 5G plans.

Digicel and TLS operate in a number of overlapping countries so there should be some synergies (for example the ability to move Digicel’s international bandwidth onto Telstra’s extensive submarine cable network to save money).

Forecast and valuation update

We assume a 1 July 2022 settlement and upgrade our EPS by ~3.5% and FCF per share by ~7% (for the first 6 years where TLS has protected status).

Our target price increases (login to view) and we retain our Add recommendation.

Four reasons we have an Add rating on TLS 

Industry dynamics have turned positive (NBN and mobile prices are increasing after 5 years of decline; TLS’s targets imply they continue to rise).

The SOTP for TLS is worth more than the current share price (and steps to release this value are underway; albeit timing is unclear).

While PNG is not without risk, this deal shows management’s ability to sensibly manage risk, and it could create further upside, all going to plan.

Underlying earnings returned to growth in 2H21 and should continue growing out to FY25

Price catalysts

Another investor day on 16th November 2021; price rises; SOTP realisation (new business units and/or media speculation about the potential IPO of Foxtel).

Risks

Key risks relate to industry pricing remaining rational and realisation of value drivers.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

Solid top-line outcome: BAP’s 1Q22 revenue was flat on the pcp, an extremely resilient result given the extent of lockdowns in the period (~70% of stores impacted) and the strength of the pcp (cycling 27% growth). Composition comprised: Trade +2%; NZ -10%; Retail -12%; and Specialist Wholesale +7%. Overall, BAP stated that non-lockdown areas are outperforming expectations. ▪ 1Q22 trade & retail: Trade/Burson revenue was up +2% on the pcp (LFL sales - 1%; cycling 8% pcp); NZ/BNT revenue was down -10% (LFL sales -15%; cycling +4%); and Retail/Autobarn revenue was down -12% (LFL sales -16%; cycling +36%). Within the Retail segment, online sales were +80% on the pcp. Stores percentages impacted by lockdown were: Trade 70%; NZ 100%; and Retail 50%. ▪ Specialist segment results: Specialist wholesale revenue is up 7% on pcp, with Auto electrical/Truckline divisions ‘performing strongly’; and WANO underperforming. ▪ GM pressure expected to be temporary: BAP stated GM was stable across Wholesale and NZ (45% of FY21 revenue); and down ~50bps Trade and Retail (~55% of FY21 revenue), driven by promotional and online pricing in lockdown areas (we assume no margin pressure witnessed in non-lockdown areas). BAP expect margins to revert once lockdowns ease. ▪ The cost base has increased vs pcp, a function of duplicated DC costs (commencement of new VIC DC), and higher group and team member support (covid related) costs. BAP noted FY22 store rollouts and refurbs are on track.

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