7 months ago, I did a piece on whether M1 and Starhub is a value opportunity or a value trap.
Back then the price is trading at $1.90. Today, we are not so far off.
Had you purchase M1, you would have gotten some good gains. That is, before the recent results were published.
Was my thesis wrong?
My thesis has always been fundamental and that thesis changes as more information is revealed and the environment changes.
This piece is about my reflection on what I see in the first quarter results. Subsequently after the announcement, M1 share price gapped down. I am struggling to see where is the strong double bottom my friend B talked about. If you manage to spot it do let me know.
I only see a huge gap that will be quite a challenge to fill up.
The valuation at this point is not much different from my previous article. The environment, from what I understand became more competitive, and M1’s result is reflective of that.
Reason for the lower profitability
The following table is taken from M1’s 1Q17 financial statements:
The nature of the business is such that M1 is largely profitable. However, what is of note is that operating expenses, out pace that of revenue growth.
On the right, I have pasted the 1Q16/17 results. We can see something similar, higher revenue but the operating expenses outpacing the revenue.
M1 provided further break down of the revenue and market share:
Mobile and International Call Services is down. Based on my last article, one of the reason given is a shift towards a plan where the subscriber do not overspend on data and international call.
Overspending on data have become the saving grace for the telecom operators for the past 3-4 years.
Back when I was reviewing the telecom operators, I couldn’t find how to grow, foreign labor migration have been stamp down since 2011.
Turns out, data revenue is good!
Number of customers is up and so is market share, so they are not losing market share.
However, all this comes at a price. If number of subscribers is up, yet total revenue is down, it is likely the overall plans are becoming more competitive. ARPU will have to go down.
My question is that does ARPU factor in cost normally, since it is Average revenue per user?
This is because acquisition cost per customer is much higher, rising from $329 to $379.
The data points to the telecom trying to be preemptive, to be competitive before the real competition comes. Plans are set more competitive with lower rates. At the same time handset discounts are getting larger.
A Glimpse at the Cash Flow
We have 2 quarters of results in, and we can see how well M1 have done.
The following is the cash flow statement for M1 in Q2:
There are some changes to the working capital, but depreciation year on year is largely similar and that operating cash flow before working capital shows a decrease but nothing to be worried about.
Here my computation of free cash flow takes: operating cash flows before working capital changes – interest paid – tax paid – purchase of fixed assets. I leave out spectrum rights as that to me feels more like an investment capital expenditure than a maintenance capital expenditure.
We get $30 mil in 2Q16 and $31 mil in 2Q17.
As a form of tracking, 2Q16 EBITDA is $77 mil and 2Q17 EBITDA is $67.5 mil
This is largely consistent. The notable difference was the purchase of spectrum which is likely one off.
I am interest to refresh my memory and see how it is versus that of Q1.
The following is the cash flow statement for M1 in Q1:
1Q16 Free Cash Flow is $47 mil and 1Q17 Free Cash Flow is $29 mil.
There is a large decrease, mainly due to higher capital expenditure. I won’t read much into this because capital expenditure is likely not going to be uniform quarter by quarter.
As a form of tracking, 1Q16 EBITDA is $78.5 mil and 1Q17 EBITDA is $73.5 mil
EBITDA wise, both quarter of results show a noticeable fall from 2016. We wonder whether this is going to be a trend.
Q2 EBITDA from Q1 shows some fall as well.
EBITDA margins according to M1 report have fallen from 40% to 35%.
The 1H16 FCF is $77 mil and 1H17 is $60 mil. Remember this excludes the $20 mil spectrum purchase, so 1H FCF could be lower. This may explain why they cut the dividend.
The 1H16 EBITDA is $155.5 mil and 1H17 is $141 mil
How much capital expenditure for the full year?
Telecom companies usually give guidance for capital expenditure as a percentage of revenue.
In my last article, I gave an estimate of $130 mil in total capital expenditure. Based on current $100 mil spending we are almost there.
If we based capex on 13% of its $1157 mil in revenue, the capital expenditure is about $150 mil. So its about an average of $140 mil.
Full Year FCF Estimation
Given this, the second half EBITDA could be $140 mil, the capital expenditure $45 mil, the interest and tax to be $15 mil and interest expense $4 mil.
This will add a FCF of $76 mil.
This is estimated to bring full year FCF to $60 + $76 = $136 mil.
M1 Ability to pay dividends
In the past, M1’s dividend payout ratio ranges around 80% excluding the special dividends.
M1 Cut its Interim dividend from $0.07 to $0.052.
Facing a falling ARPU, EBITDA and higher capital expenditure that is the prudent thing to do.
Much of whether M1 could stabilize its dividend depends on its future cash flow.
M1 annualized dividend for the year works out to be $0.111
M1 have 930 mil shares. This means they will be paying out $0.111 x 930 = $103 mil.
Based on the estimated FCF minus the $20 mil spectrum cost, it works out to be quite close to this.
The question is whether M1 have stabilized or not. The competition have not come out yet.
M1 have long term debt of $350 mil and short term debt of $76.6 mil. They have cash on hand of $6.1 mil.
Thus, net debt is $420 mil.
M1 total assets amount to $1189 mil.
The net debt to asset is 35%. This has edge up a fair bit from the $250 mil long term debt it used to own. However, telecom operators, due to their strong cash flow, and conservative gearing, can usually gear up a little for capital expenditure spending.
M1 current trades at $1.88. With the 930 mil shares outstanding, this bring their market capitalization to $1748 mil.
The Enterprise Value (EV), or Market Capitalization + Net Debt = $1748 + $420 = $2,168 mil.
Telecom companies are not asset based business, but businesses known for its stream of cash flows that can be volatile at times, but generally predictable.
A standard measure would be to use EV/ EBITDA. This is to see how many times we are paying for the company and its debts, with the cash flow of the telecom.
If we annualized 1H17 EBITDA of $141 mil, we get $282 mil.
The EV/EBITDA works out to be 7.7 times.
7.7 times is quite fair in my dictionary. Usually, telecom at 8 times are fair, 6 times is attractive.
The dividend at 5.9% certainly looks attractive, however, I could have remember M1 trading at much higher (7%) dividends.
If I were to describe the business of telecommunications, they seem to go through periods of game theory like equilibrium. Then they compete further with each other and each of them end up with a smaller pie.
Still, despite the competition, the free cash flow is still commendable. This is as long as they do not require extremely large capital expenditure.
Part of the challenges of the current environment is that they require expenditure in spectrum and other forms of software investments.
5G is very fast, but it demands that you have adequate spectrum. Thus they do not have a choice but to do something about it.
That is not to say the telecom operators can only compete on price. The next evolution of telecom operators is the set of application layer that resides on top of the data. So its from voice -> data -> application.
The problem is at the application layer, the telecom operators not only compete amongst themselves but other software companies.
If whatever M1 management say comes to fruition, then at this price its not a bad purchase.
You get a fair EV/EBITDA but a business that is predictable, cash flow generating, with economies of scope.
M1 is competing with Starhub and Singtel now, before TPG comes into the picture and I believe when TPG comes in they are ready.
However, we always go back to the base case. If you have a pie that is already saturated and you have some new entrants, everyone’s pie shrinks. They become more competitive.
If we purchase M1 because its 6% dividend is sustainable, recurring, what happens when their EBITDA that they can earn from the pie shrinks?
They look more expensive. The value point is definitely during the hay days when EV/EBITDA is like 6-7 times for Starhub and M1 WITH THE UPCOMING ISSUES LAID OUT IN THE OPEN.
The current situation is as such.
Again, I repeat, this is a good purchase if they manage to make use of their economies of scope.