Morningstar Australia analyst Brain Han recently downgraded TPG Telecom TPG to a no moat rating from narrow. This article will explore the significance of the economic moat and how TPG found itself in this position despite its shares still presenting an attractive proposition.

More information about how Morningstar arrives at their moat, fair value and uncertainty ratings are available at the end of this article.

What is an economic moat?

In a commercial environment where success inevitably attracts competition, an economic moat becomes important to ensure companies hold a competitive advantage over its peers.

The Morningstar Economic Moat Rating refers to a company’s ability to retain this competitive advantage over extended periods. A wide moat rating indicates a company whose competitive advantage could span over 20 years whilst a narrow moat lowers this range to 10 years. Having no moat implies that a company either has no advantage or a minimal amount that could erode rapidly. You can read more about the sources of economic moats here.

Who is TPG Telecom?

TPG Telecom is one of Australia’s leading (behind Telstra and Optus) providers of mobile and broadband services to consumer, business, enterprise, government and wholesale customers. The group operates its services through various brands including Vodafone, TPG and iiNet among others.

2020 saw TPG merge with Vodafone to become a fully integrated player in the Australian telco market, navigating the National Broadband Network’s (“NBN”) margin crushing impact. Most recently a regional mobile infrastructure-sharing deal was announced that would allow Optus to use TPG’s excess mobile spectrum to improve capacity in return for granting TPG access to Optus mobile network assets to improve its regional presence.

So why the downgrade?

After taking a step back and exploring the state of the industry, Han believes that TPG no longer holds a narrow moat. This assessment is underpinned by larger than expected capital expenditure in the mobile division and in business simplification since ithe merger with Vodafone in 2020.

Exacerbating the higher spend is a lack of improvement in mobile subscriber market share and revenue, as well as lower margins from the reliance on government-owned infrastructure given high access costs. Given these factors, Morningstar is no longer confident in TPG’s ability to sustainably generate returns above the cost of capital over the long term.   

The company’s latest results saw TPG’s largest revenue division (mobile) remain stagnant in market share at sub 18%. This result solidified TPG’s position behind the colossal shadows left by Telstra and Optus.  

TPG’s mobile division, Vodafone Australia, is forecast to generate over 50% of its midcycle earnings before interest, taxes, depreciation and amortisation "EBITDA". Midcycle refers to the longest stretch of TPG’s economic cycle with moderate capital expenditures and moderate EBITDA growth. This contrasts with shorter period of high capital expenditures and lower EBITDA and lower capital expenditures and higher EBITDA.

Around 30% of EBITDA comes from the enterprise, government and wholesale division estimate. We also believe this business unit also lacks an economic moat.

The remaining 20% of EBITDA falls to the fixed-line broadband consumer division that Han sees as lacking any durable competitive advantage. Whilst TPG hold a substantial market share (20%+) in the division, this has been on a steady decline since 2012 following the rollout of the NBN– a federal initiative of fibre communications network that all Australian players resell to customers. Providing broadband access to consumers essentially has no barriers to entry and NBN’s high access costs constrain the margins of TPG and other providers resulting in limited capacity for product differentiation besides lowering prices for consumers.   

Consistently high returns above cost of capital are required to classify a company as having a moat. TPG’s return on invested capital currently hovers around 5% and in the next five years is projected to move past 6%. The medium-term may also see earnings benefits from a decline in capital expenditure towards the end of 2026 following a spike from the 5G rollout, IT modernisation and business simplification.  

However, with an estimated weighted average cost of capital (“WACC”) of 7.2%, Han is unsure whether TPG can maintain returns above its WACC in the long term. Furthermore, the stagnant nature of mobile revenue share creates doubt that any excess returns in the medium term can be maintained through the next cycle.

Share still trading at a discount

A downgrade to the moat rating also accompanies a 3% fall in fair value to an estimated $6.40 per share.

A medium uncertainty rating has been applied due to the risks of the 2020 merger with Vodafone based on the potential misalignment between the two entities after the abrupt resignation of the TPG Chairman David Teoh from the board in March 2021. Furthermore, current transformation plans have proven complex and costly as realising the fruit of this labour dangles further into the future.

Despite this, revenue is forecasted to grow from $5.5 billion in 2023 to $6.6 billion by 2028 driven by mobile revenue and cross-selling of the merged entity’s full suite of products.

Beyond 2028, top-line growth is projected to be ~4% per year with the group’s EBITDA margin to settle at 35% in the long term. Han’s valuation implies a 2026 EV/EBITDA of 7.3x and a P/E of 41.5 with a dividend yield of 3.9%.

TPG currently sits at approximately $5 per share trading around 20% below Morningstar’s estimated fair value of $6.40.

  • Moat Rating: None
  • Share Price on 13/09/2024: $4.93
  • Fair Value: $6.40
  • Price to Fair Value: 0.77 (Undervalued)
  • Uncertainty Rating: Medium

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Terms used in this article

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn more about how to identify companies with an economic moat, read this article by Mark LaMonica.

Uncertainty Rating: Morningstar’s Uncertainty Rating is designed to capture the range of potential outcomes for a company. An investor can think of this as the underlying risk of the business. For higher risk businesses with wider ranges of potential outcomes an investor should consider a larger margin of safety or difference between the estimate of what a share is worth and how much an investor pays. This rating is used to assign the margin of safety required before investing, which in turn explicitly drives our stock star rating system. The Uncertainty Rating is aimed at identifying the confidence we should have in assigning a fair value estimate for a stock. Read more about business risk and margin of safety here.